European Infrastructure Finance Yearbook - SP

Infrastructure Finance Ratings

European InfrastructureFinance Yearbook 2007/08

November 2007

20 Canada SquareCanary WharfLondon E14 5LH

www.standardandpoors.com

STANDARD & POOR’S RATINGS SERVICES

NOVEMBER 2007 ■ 1STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK

CONTENTS

CONTENTS

Introduction

2007: New Challenges And Threats, But Sector Remains Robust 3Michael Wilkins

Infrastructure CommentariesHow Infrastructure Assets Have Weathered A Decade Of Storms 4Lidia Polakovic, Michael Wilkins, Jonathan Manley, and Peter Kernan

The Changing Face Of Infrastructure Finance: Beware The Acquisition Hybrid 8Michael Wilkins and Taron Wade

European Utilities 12

Credit FAQ: Assessing The Credit Implications Of EC Legislative Proposals For 13The Internal Energy MarketPeter Kernan and Beatrice de Taisne

Nuclear Power In The EU: The Sleeping Giant Is Only Gradually Waking Up 17Hugues de la Presle and Peter Kernan

Volts And Jolts: What To Expect As Russia Restructures Its Power Markets 22Eugene Korovin and Peter Kernan

Combating Climate Change In The EU: Risks And Rewards For European Utilities 33Peter Kernan, Michael Wilkins, Mark Schindele, and Hugues de la Presle

Summary analysesElectricite de France S.A. 40

Endesa S.A. 41

Enel SpA 42

E.ON AG 43

Gaz de France S.A. 44

Iberdrola S.A. 45

RWE AG 46

Scottish and Southern Energy PLC 47

Suez S.A. 48

Vattenfall AB 49

Transportation Infrastructure 51

Skies Remain Clear For European Airports, Governance Increasingly Important 52Alexandre de Lestrange and Lidia Polakovic

BAA Ltd. 56Alexandre de Lestrange and Michael Wilkins

Channel Link Enterprises Finance PLC 67Alexandre de Lestrange, Michela Bariletti, and Michael Wilkins

Summary analysesCopenhagen Airports A/S 85

Deutsche Bahn AG 86

DP World Ltd. 87

Sanef 89

VINCI S.A. 90

Project Finance and Public-Private Partnerships 92

Updated Project Finance Summary Debt Rating Criteria 93Terry A Pratt, Ian Greer, Arthur F Simonson, and Lidia Polakovic

Credit FAQ: Accreting Debt Obligations And The Road To Investment Grade 105For Infrastructure ConcessionsPaul B Calder, Kurt Forsgren, Ian Greer, and Lidia Polakovic

Credit FAQ: The Evolving Landscape For Subordinated Debt In Project Finance 116Andrew Palmer, Kurt Forsgren, Terry A Pratt, Paul B Calder, Lidia Polakovic,and Santiago Carniado

Credit FAQ: Recently Upgraded Nakilat Provides Case Study For Credit 122Analysis Of LNG Shipping ProjectsKarim Nassif, Terry A Pratt, and Michael Wilkins

Standard & Poor’s Methodology For Setting The Capital Charge On Project 126Finance TransactionsLidia Polakovic, Parvathy Iyer, Arthur F Simonson, Dick P Smith, and David Veno

Sweden Moves Closer To PPP Model As Alternative Financing For 129Infrastructure AssetsLidia Polakovic, Karin Erlander, and Michael Wilkins

Summary analysesAbu Dhabi National Energy Company PJSC 132

Autoroutes Paris-Rhin-Rhone 133

Metronet Rail BCV Finance PLC/Metronet Rail SSL Finance PLC 136

Peterborough (Progress Health) PLC 138

Transform Schools (North Lanarkshire) Funding PLC 142

Ratings List 144

Key Analytical Contacts 149

CONTENTS

CONTENTS CONTD.

STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK2 ■ NOVEMBER 2007

The year 2007 marks Standard & Poor’s Infrastructure Finance Ratings group’s 10th anniversary.I am therefore delighted to introduce this year’s European Infrastructure Finance Yearbook, inwhich we discuss the continuing evolution of the asset class and highlight the year’s key

transactions, sectors, and trends. In addition we set out the latest developments in our ratings criteriaand methodology. We have also taken the opportunity to look back over the decade and examine thephenomenal growth the asset class has experienced as well as the challenges it has faced.

In accordance with the past few years, throughout 2007 infrastructure has remained a highly soughtafter asset class in the financial markets, continuing to attract new investors with its reputation for lowvolatility and high stability. Yet, with this sustained growth in appetite has come a simultaneous pushon the boundaries of infrastructure finance--with investors eager to pay higher acquisition multiples andemploy novel financing techniques to purchase infrastructure assets. Consequently, the level of creditrisk across the sector has escalated, as debt multiples have continued to creep upward.

In particular, Standard & Poor’s has witnessed an increasing number of infrastructure assets beingpurchased using a new form of acquisition financing in the debt markets. When acquiring bothtraditional assets, such as water and toll roads, and nontraditional assets, for example motorway servicestations, participants are increasingly combining project finance structuring techniques with covenantsprevalent in corporate-style leveraged finance facilities. Standard & Poor’s believes such structuringtechniques can involve significantly more credit risk than is usual among previous infrastructure financetransactions, as favorable debt terms are often coming at the expense of necessary protections.Consequently, we have warned market participants that, as credit markets become increasingly tight--as has been the case in the second half of 2007--some of these more loosely structured and highlyleveraged acquisition loans may find it hard to attract lender and investor interest. Nevertheless, wehave also been keen to highlight that for well-structured infrastructure finance transactions fundingtraditional infrastructure assets--such as the Thames Water refinancing transaction--investor appetitelooks set to remain, due to the assets’ strong credit quality. For this reason, such transactions are likelyto show significant resilience in the face of the current market volatility.

Indeed, such stability has been the case for infrastructure assets throughout the past decade, despitesubstantial market shocks. Notably, Standard & Poor’s has analyzed the project, utility, andtransportation sectors through numerous difficult environments--such as the Asian crisis that threatenedmany credits across the region in 1997, as well as the California power crisis, Enron Corp. bankruptcy,Brazilian energy crisis, and events of Sept. 11, 2001, all of which placed ratings under downwardpressure in later years. Despite such pressures, on the whole, project and infrastructure credits haveremained robust in the longer term, and the credit trends of the past decade illustrate the strength of theinfrastructure sector.

Unsurprising, therefore, that the market has continued to expand--with the booming global economydriving demand for supporting infrastructure. Consequently, the demand for Standard & Poor’s ratingshas similarly grown in the sector, with the number of global project finance ratings alone reaching 304in total at the beginning of this year, a dramatic increase from the 93 we rated in 1997.

The articles within this year’s European Infrastructure Finance Yearbook reflect this continueddevelopment of the infrastructure market. We discuss the growth in project, utility, and transportationfinance transactions in new jurisdictions--such as Russia and Eastern Europe--as well as our approach torating increasingly complex structuring techniques. Importantly, Standard & Poor’s continues to closelyfollow the trends across the infrastructure sector, extending and revising our criteria to enable theappropriate assessment of risk originating from the new markets, new structures, and new avenues ofinfrastructure ownership.

I therefore hope you find this 2007 European Infrastructure Finance Yearbook of considerable useand we look forward to receiving any feedback or questions you may have on this publication.

INTRODUCTION

2007: New Challenges And Threats, But SectorRemains Robust

Michael WilkinsManaging Director and Head of Infrastructure Finance Ratings

INTRODUCTION


4 ■ NOVEMBER 2007 STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK

COMMENTARY

Chart 1Breakdown Of Projects By Sector,

December 1997

Chart 2Breakdown Of Projects By Sector,

May 2007

Over the past decade, Standard & Poor’sRatings Services has witnessedphenomenal growth in demand for

infrastructure assets. A highly sought after assetclass in the financial markets, infrastructurebenefits from its reputation for stability andflexibility to respond to changing investor needs.The sector is evolving, with assets becoming morevaried and the financial structures that supporttheir financings increasingly sophisticated, makingrisk analysis more complex than ever.This year marks Standard & Poor’s

Infrastructure Finance Ratings group’s 10thanniversary. It therefore seems appropriate toreview the highs and lows of the past decade, andto consider how infrastructure has matured as anasset class.In 1997, infrastructure finance faced a difficult

environment. The Asian crisis was unfolding,threatening many project and infrastructurecredits rated by Standard & Poor’s across theregion. In many cases the crisis derailed projectsat all stages of the pipeline--from many indevelopment infancy to a handful ready to closeon their financings. Market shocks have followed.Notably, the California power crisis, Enron Corp.bankruptcy, Brazilian energy crisis, and events ofSept. 11, 2001, caused widespread disruption inthe project, utility, and transportation sectors.Through it all, though, infrastructure assets

have shown resilience, and the market continuesto grow. This should surprise few. As the globaleconomy has boomed, the need for supportinginfrastructure has exploded, which has alsoresulted in a significant rise in the number ofStandard & Poor’s ratings in the sector. Project

finance ratings alone rose to 304 at the beginningof 2007, from 93 in 1997. Project financetransactions have also spread globally to marketssuch as Latin America, the Middle East, and--more recently--Eastern Europe. New forms ofproject finance have gained popularity, with theU.K. public-private partnership (PPP) marketgrowing in importance over the decade. Thismarket continues to expand, with severalcountries developing their own PPP models--including Canada, Australia, and most recentlythe U.S.--as a means of delivering public sectorservices using private sector expertise. Increasinglymore diverse assets are being presented to us asinfrastructure (see charts 1 and 2 below), andinfrastructure finance now includes wind andsolar power projects, as well as more unusualasset types such as stadiums and car parks.The Infrastructure Finance Ratings team has

followed the cycles of infrastructure finance of thepast decade and studied their causes and effects.Here are some of the decisive moments in thedevelopment of the infrastructure asset class.

Power Projects Hit By FallingCommodity PricesAfter the Asian financial crisis in 1997-1998, themajority of infrastructure assets enjoyed ratingstability. This all changed in 2002, when ratedproject credit quality precipitously fell. Collapsingcommodity prices drove many of the negativecredit trends. Most of the project financedowngrades occurred in the U.S. power sector,affecting projects exposed to contracts withweakening power offtakers in particular. Notably,a number of rated AES Corp. projects that sold

Publication Date:

Oct. 31, 2007

Primary Credit Analysts:Lidia Polakovic,London,(44) 20-7176-3985

Michael Wilkins,London,(44) 20-7176-3528

Secondary Credit Analysts:Arthur F Simonson,New York,(1) 212-438-2094

Ian Greer,Melbourne,(61) 3-9631-2032

Peter Rigby,New York,(1) 212-438-2085

Other Secondary CreditAnalysts:Jonathan Manley,London,(44) 20-7176-3952

Peter Kernan,London,(44) 20-7176-3618

Paul B Calder, CFA,Toronto,(1) 416-507-2523

HOW INFRASTRUCTURE ASSETS HAVE WEATHERED ADECADE OF STORMS

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Investment grade Speculative grade

ject Finance Rating Distribution: Investment Grade Versus Speculative Gr

© Standard & Poor's 2007.

STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK NOVEMBER 2007 ■ 7

COMMENTARY

The ever present demand for infrastructureassets across the globe ensures that the drivers ofinfrastructure are set to remain. As the sectormatures, so too will the Infrastructure Financeteam’s credit risk analysis methodology andanalytical approach.

NoteAdditional research by Deepti Hemnani, ArchanaSharma, Ganesh Iyer, and Kaustubh Shrotriya,and by Caroline Hyde of Moorgate Group. ■

Bank lenders and institutional investors havetraded favorable debt terms against themanagement of credit risk during the

infrastructure finance boom of the past 18months. Now, with the cycle turning in the globalcredit markets, loosely structured and highlyleveraged acquisition loans are looking far lessattractive. As a result, it is estimated that up to$34 billion of leveraged infrastructure loans maybe left paralyzed under current market conditions.Cheap debt with relatively generous terms has

been the order of the day among infrastructuresponsors. To meet market demand, banks havecombined project finance structuring techniqueswith covenants prevalent in leveragedfinance facilities--allowing sponsors to acquireinfrastructure assets at record-breakingdebt multiples.Despite the advantages for borrowers, Standard

& Poor’s Ratings Services believes that this newform of acquisition hybrid poses a significantcredit risk to the infrastructure sector. Manyassets recently purchased for eye-wateringacquisition multiples have failed to boast theoperating and cash flow strengths assumed typicalof infrastructure assets. Such risks are likely to beexacerbated as credit markets become increasinglyvolatile and investor confidence fragile.With $332 billion in leveraged loans currently

sitting on banks’ balance sheets globally, bankersare unlikely to be keen to lend to infrastructureassets in the current climate without comfort thatcredit risks are well mitigated. Investors andlenders alike therefore need to examine the risksassociated with each individual transaction, and ifnecessary seek more credit protection than iscurrently being provided within the hybridstructure to ensure that the level of debt can besupported by the underlying asset. This isparticularly pertinent as new assets are broughtunder the infrastructure umbrella--with car parks,motorway service stations, and motor vehiclecertificates now claiming to be stronginfrastructure assets.

Breaking New Boundaries: Hunger ForInfrastructure Drives DevelopmentOver the past few years the boundaries ofinfrastructure finance have been increasinglypushed, with investors hungry for new types ofassets and financing techniques. Consequently, thelines between project finance and leveragedfinance have become evermore blurred, with

investors marrying together structuring techniquesfrom both financing classes to acquireinfrastructure assets. Crucially, the high debtmultiples usually associated with project financetransactions have been adopted in conjunctionwith the relatively flexible controls, hurried duediligence, and weak security packages morecommon in LBOs. As a result, increased debtmultiples are often coming at the expense ofnecessary risk mitigants.Since 2006 a phenomenal appetite for

infrastructure assets has spread worldwide. This,in turn, has fuelled a surge in the number ofacquisitions within the sector, making it asignificant area of growth for the syndicated loanmarket. Landmark deals include the purchase ofU.K.-based airport operator BAA Ltd.(BBB+/Watch Neg/NR) by a consortium led byGrupo Ferrovial S.A. in February 2006 for $30.2billion, the acquisition of the Indiana Toll Roadfor $3.8 billion by Macquarie InfrastructureGroup and Cintra Concesiones de Infraestructurasde Transporte, and Goldman Sachs’ AdmiralAcquisitions consortium’s £2.8 billion acquisitionof Associated British Ports (ABP).

Fusion Of Project Finance AndLeveraged FinanceAs for the financing of “greenfield” infrastructureassets, investors have turned toward projectfinance to raise funds when acquiring matureinfrastructure assets--securing high leveragemultiples due to the stable cash flows andmonopolistic environment. They have thenincorporated leveraged finance structuringtechniques instead of carrying out an LBO of theasset as would traditionally have been the case forthe acquisition of mature infrastructure assets(see table on next page for the various structuringtechniques typically associated with leveragedfinance transactions and project financetransactions, respectively).Of key concern for Standard & Poor’s is that,

in combining techniques, investors have beentrading favorable debt terms against themanagement of risk. Often we are seeing newinfrastructure acquisition financing structuresemploying structural features, such as shortshareholder lock-in periods, that are weaker thanthose of traditional transactions, coupled with avery aggressive financial structure. ABP, forexample, was purchased for £2.8 billion with anenterprise value (EV)-to-EBITDA ratio of 16.6x.

COMMENTARY

THE CHANGING FACE OF INFRASTRUCTURE FINANCE:BEWARE THE ACQUISITION HYBRID


Publication Date:

Sept. 7, 2007

Primary Credit Analyst:Michael Wilkins,London,(44) 20-7176-3528

Leveraged Finance& Recovery:Taron Wade,London,(44) 20-7176-3661

Despite the asset’s strong monopolistic positionand stable cash flows, these terms are unlikely tofully mitigate risk arising from the high level ofdebt. Nor are they likely to mitigate market riskssuch as the increasing environmental andregulatory hurdles limiting ABP’s ability toexpand capacity in the future.

Infrastructure--An Ever ExpandingAsset Class?For the past 18 months, sponsors have also beenusing the hybrid structure to acquire assets nottraditionally considered as infrastructure. Theseassets do not benefit from the significant trackrecord of other sectors such as ports and airportsand therefore may not be suitable to support highdebt multiples, lacking the necessary long-termstable cash flows or a strong monopoly positionin the market.The recent refinancing of Autobahn Tank &

Rast Holding GmbH, a German motorwayservice area operator, is a clear example of themarket opening up to new assets and financingacquisitions that would not previously have beenrecognized as infrastructure-style deals. Indeed,the initial acquisition of Tank & Rast by private-equity investor Terra Firma for €1.1 billion inNovember 2004 involved traditional leveragedfinance techniques. The acquisition was financedusing an all-senior debt facility, with a debtmultiple of 6x debt to EBITDA.As little as two years later, in June 2006, Terra

Firma was able to refinance the debt, obtaininggreater leverage at a cheaper price. Therefinancing transaction involved a €1.2 billionseven-year senior loan with a cash sweep, and

leverage was about 8x. Significantly thinnermargins were attained via the refinancing--withpricing falling to a range of 125 basis points (bps)to 150 bps in 2006, from a range of 212.5 bps to262.5 bps in 2004. Importantly, the arrangers ofthe refinancing--Royal Bank of Scotland, BarclaysCapital, Société Générale, and West LB--marketedthe transaction as infrastructure play, highlightingthe asset’s 90% market share and stable,predictable cash flows.Investors and lenders need to be aware of the

credit risk of applying significant leverage to anew asset type. The experience of U.K. motorwayservice operator Welcome Break Groupdemonstrates the pitfalls of assuming that thisasset class can support significant levels of debt.Standard & Poor’s believes that applyinginfrastructure-style financing techniques to lessmature asset types could serve to undermine thesector’s reputation for strong, long-term revenueflows if appropriate risk mitigants arenot employed.

The Origins Of The Acquisition HybridHybrid acquisition financing structures are fairlynew to the infrastructure sector, with the SouthEast Water deal in 2003 heralding the firsttransaction of this kind on a large scale. It wasthe subsequent flurry of French toll road deals in2005 and 2006 that brought infrastructureacquisition transactions into the mainstream--withEiffarie’s purchase of Autoroutes Paris-Rhin-Rhone (APRR) providing a template forfuture transactions.Techniques from both leveraged finance and

project finance were evident in the APRR

COMMENTARY


Leveraged finance Project finance

Corporate entity in competitive environment Asset with stable cash flows over the long-term, monopolisticenvironment

Debt capacity dictated by market-driven multiples Debt capacity dictated by discounted cash flows

Medium-term maturity, lower leverage, bullet repayment Long-term maturity, higher leverage, amortizing repayment, lowermargins

Standardized due diligence Detailed due diligence

Key ratio: debt to EBITDA Key ratio: loan to project life coverage

Flexible financial undertakings Fixed financing structure, monitored/ updated

Capital expenditure lines accounted for, but not Future expenditure (i.e., restoration of assets) accounted formandatory future capital expenditure

Standardized security interest charges Ring-fencing security and "cash waterfall" controls

Leveraged Finance And Project Finance Structuring Techniques

0

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1999 2000 2001 2002 2003 2004 2005 2006 2007

(Bil. )

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320

(No. oftransactions)

First quarter Second quarter Third quarter

Fourth quarter Transaction count*

*Transaction count takes first- and second-lien portions of a single transaction asone event and excludes any amendments. For the first half of 2007, the transactioncount was 214.



Contractual terms have also been weakeningelsewhere in the loan markets, with theintroduction of “covenant-lite” LBOs furtherreducing lenders’ control over borrowers’performance. Furthermore, Standard & Poor’s hasrecorded that the level of senior debt amortizingwithin European LBOs has dropped steeply, to15% at the beginning of 2007 from 50% in 2001.With risk mitigants deteriorating in this fashionacross the loan market in general, Standard &Poor’s does not believe that the infrastructureasset class can withstand a continueddeterioration in underwriting quality. Hybridacquisitions must therefore be restricted toinfrastructure assets operating withinmonopolistic environments with stable cash flowsover the long term. Moreover, high leverageshould be accompanied by the necessarystructural package and creditor protections.

NotesAdditional data provided by Thomson Financial.Additional research by Caroline Hyde ofMoorgate Group. ■

COMMENTARY

UTILITIES

EUROPEAN UTILITIES


Once again, while the European utility sector continues to exhibit generally strong creditcharacteristics, credit quality has come under pressure--with increased debt-financed M&Aactivity and heightened levels of regulatory risk the principal drivers of this pressure. Favorable

operating conditions have, however, continued for many utilities--particularly among generators andvertically integrated power companies in the deregulated markets, where high power prices and strongfree operating cash flows have remained a source of credit strength.

M&A activity has continued at a high level since 2006, and has resulted in several downgrades--atE.ON, EDP, Enel, and Iberdrola for example--and a number of CreditWatch listings across the sector.Crucially, these negative rating actions have been catalyzed by a weakening of companies’ financialprofiles following debt-financed acquisitions, as exemplified by Enel’s downgrade to ‘A’ from ‘A+’, withall ratings remaining on CreditWatch with negative implications, following its acquisition of Endesa. Webelieve that the consolidation trend will continue and is likely to keep ratings under pressure. Of the top20 European utilities, five companies are on CreditWatch negative as a result of M&A activity (Enel,Iberdrola, Endesa, Scottish Power, and Gaz de France) and a further four companies have negativeoutlooks.

Meanwhile, the European Commission’s ongoing scrutiny of European utilities, together with therecently announced legislative proposals to further liberalize the internal energy markets, has highlightedthe regulatory and political risk many companies remain exposed to. In particular, of the measuresproposed, any forced ownership unbundling of transmission grids would have the greatest impact oncredit quality, affecting vertically integrated utilities in Germany (such as E.ON and RWE), France,(EDF and GDF), and Greece (Public Power Corp.). At this stage, we do not factor in any assumptionthat those companies that currently own and operate transmission networks will be forced to sell theirnetworks. We believe there continues to be significant uncertainty about both the final form of anylegislative package and whether ownership unbundling will be required, as there is no unanimitybetween the EC and the member states about whether unbundling is necessary.

The future direction of climate change policies adds a further layer of uncertainty and risk to theutility sector. Phase 2 of the EU’s Emission Trading Scheme comes into force from Jan. 1, 2008. Giventhe high level of uncertainty over future climate policy initiatives and long-term carbon pricing, thisissue will remain a significant challenge for generators, especially when taking long-term investmentdecisions. Nevertheless, it is clear that the outlook for both renewable and nuclear energy investmenthas improved and will continue to do so due to the heightened global focus on environmental issues,while that of coal--the most CO2-intensive fuel--has weakened. The need for technologicaldevelopments to reduce the CO2 intensity of coal will be key to the future of coal-fired generation.

Accordingly, the articles included here provide an important insight into the current environmentEuropean utilities face, as well as detailed analyses of the resulting credit issues.

Based in London, Paris, Frankfurt, Madrid, Milan, Moscow, and Stockholm, our regional utilitiesinfrastructure analysts welcome your feedback; their contact details are listed at the end of this book.Please do not hesitate to contact me, or any of the analysts, if you require further information.

Peter KKernanManaging Director and Team LeaderEuropean Utilities Team


On Sept. 19, 2007, the EuropeanCommission (EC) published a package oflegislative proposals for the internal

energy market. One of the EC’s principal goals isto correct what it sees as structural failings insome EU electricity and gas markets. According tothe EC, “the current rules on the separation ofnetwork activities from supply and production ofenergy do not ensure proper market functioning.”The EC recommends that this be remedied eitherthrough ownership unbundling, so that a singlecompany could no longer own transmission andgeneration or supply activities, or byimplementing an independent system operator(ISO) model that would make it possible forexisting vertically integrated companies to retainnetwork ownership, provided that the assets areoperated completely independently from thegeneration and supply operations.

To highlight the potential implications of theEC’s findings for the credit quality of Europeanutilities, Standard & Poor’s Ratings Servicesaddresses below some of the most frequentquestions we have been receiving.

Frequently Asked QuestionsWhat are the key potential credit stress points inthe draft legislative package?The measure that could have the most markedeffect on credit ratings would be the unbundlingof network assets by vertically integrated utilities.The EC’s current proposals include unbundling asthe default option, with the possibility formember states to apply for a derogation and usethe ISO model.

What is the next stage in the process? The EC’s proposal now has to go through thenormal codecision process with the EuropeanParliament and European Council, whereby bothinstitutions can amend the current text in thecourse of two readings. A third reading allows forformal negotiations between the two institutionsif they cannot agree. Standard & Poor’sunderstands that there are some stronglydivergent views within and between the memberstates on the proposals, and specifically on thesubject of ownership unbundling. As such, webelieve that some member states and EUparliamentarians could work to alter or remove

some of the proposals--specifically to take out oneor both of the proposals for the ownership andoperation of transmission networks.

Which member states would be most affected?A number of member states, including the U.K.,Sweden, Portugal, Italy, and Spain, have alreadyimplemented ownership unbundling oftransmission networks. For these countries, alegal requirement to unbundle would have noimpact on domestic energy markets. Somemember states, however, such as France,Germany, and Greece do not currently requireownership unbundling of transmission networks.The domestic energy markets of these countriescould therefore be significantly affected by anyobligation to implement ownership unbundling.

When would the member states have toimplement the legislative package? The earliest member states would have toimplement the unbundling and/or ISOrequirements is likely to be around 2012 on thebasis of a normal legislative procedure andassuming that the current text is the one that isfinally adopted. The text could change during thecourse of the legislative debate, however, andimplementation could be delayed beyond 2012, asit is the member states who determine the timingof their domestic legislative programs.

What assumption do the ratings on affectedcompanies make about the likely outcome of thelegislative process?At this stage, we do not factor in any assumptionthat those companies that currently own andoperate transmission networks will be forced tosell their networks or will pre-empt a potentiallegislative requirement by unilaterally deciding tosell their networks. We believe that therecontinues to be significant uncertainty about boththe final form of any legislative package andwhether ownership unbundling will be required,as there is no unanimity between the EC and themember states about whether unbundling isnecessary. For example, there is significantopposition to forced ownership unbundling inFrance and Germany, two of the largest and mostinfluential member states, which, if sustained,increases the likelihood that an alternative

UTILITIES

CREDIT FAQ: ASSESSING THE CREDIT IMPLICATIONSOF EC LEGISLATIVE PROPOSALS FOR THE INTERNALENERGY MARKET

Publication Date:

Sept. 21, 2007

Primary Credit Analysts: Peter Kernan, London, (44) 20-7176-3618

Beatrice de Taisne, London, (44) 20-7176-3938

UTILITIES

approach to ownership unbundling--such as theISO model or some other proposal--will beincluded in the final legislation. In addition, evenif ownership unbundling were required it ispossible that the affected companies couldmitigate the impact on credit ratings by using anyreceived proceeds to reduce debt.

Why does the vertically integrated model supportcredit quality and credit ratings?From a rating perspective, the European utilitysector has favorable credit characteristics, asreflected in the relatively strong credit ratings onmany of the largest companies in the sector. Oneof the key factors underpinning this creditstrength is that many of the rated utilities ownmonopoly transmission and/or distributionnetworks whose cash flow and earnings arerelatively stable and low risk. These favorablecredit characteristics provide strong support fordebt capacity and credit ratings. Stand-alone EUtransmission and distribution companies aretypically rated in either the ‘AA’ or ‘A’ categories,depending on financial risk factors such asbalance sheet leverage, dividend policy, andacquisition appetite. National Grid PLC, forexample, is rated ‘A-’, while the smaller Danishnational energy transmission companyEnerginet.dk SOV is rated ‘AA+’.

On the other hand, the EU electricity generationand supply markets are open and competitive(albeit that there are significantly different levelsof competition within different member states),and are therefore characterized by actual orpotential earnings volatility. Wholesale and retailprices are largely determined by the market(although some member states continue to setregulated supply tariffs), and generation andsupply businesses face price and volume volatilityand lack revenue and earnings predictability.Accordingly, generation and supply businesses areinherently riskier from a credit perspective thantransmission and distribution businesses.

The vertical integration model bears lowercredit risk than generation only and generationand supply models, as the ownership of anetwork business provides a relatively stable, andpredictable, regulated earnings base, underpinningcash flows and borrowing capacity. Theintegration of generation with supply operations(providing a customer base to which power canbe sold), and generation and supply operations

with network operations, provides a strongcompetitive advantage for many market participants.

How common is the vertically integrated model?The predominant business model in the EUelectricity market is that of vertical integration,which combines generation and supply operationswith distribution and/or transmission networks.Of the top 20 rated European utilities (see tableon next page), 15 are vertically integratedcompanies, for which network earnings accountfor a significant share of consolidated earningsand represent a key credit strength.

Of the 15 vertically integrated utilities, six owndistribution networks only and nine owndistribution and transmission networks, of whichseven also operate transmission networks. Theseven utilities that own and operate transmissionnetworks are E.ON AG (A/Stable/A-1), RWE AG(A+/Negative/A-1), EnBW Energie Baden-Wuerttemberg AG (A-/Stable/A-2), and VattenfallAB (A-/Stable/A-2) (who all own and operateregional electricity transmission networks inGermany), Electricite de France S.A. (EDF; AA-/Stable/A-1+) and Gaz de France S.A. (AA-/WatchNeg/A-1+) (who respectively own and operate theelectricity and gas transmission networks inFrance), and Public Power Corp. S.A.(BBB+/Stable/--) (which owns and operates theelectricity transmission network in Greece).Scottish Power PLC (A-/Watch Neg/A-2) andScottish and Southern Energy PLC (A+/Stable/A-1) own transmission networks in Scotland, butthese networks are operated by National GridPLC (A-/Stable/A-2), which provides an exampleof a functioning ISO model.

Would ownership unbundling of transmissionnetworks threaten the ratings of affectedcompanies? Yes. Ownership unbundling would increase theoverall risk and volatility of the consolidatedbusiness model. As such, if the impact ofunbundling were not offset by--for example--either a reduction in overall debt and materiallystronger forward cash flow credit protectionmeasures, or the adoption of compensatingstrategic measures (such as the use of proceedsfrom unbundling to acquire other low-riskearnings streams), ratings would be threatened.


Would ownership unbundling automaticallyresult in lower ratings?No. While ownership unbundling of transmissionnetworks would increase consolidated businessrisk by reducing the share of earnings and cashflow generated from monopoly operations, andincreasing the proportion of earnings generatedfrom more volatile and competitively exposedgeneration and supply operations, this could becompensated for by lowering the overall leverageand financial risk of the group. In other words, itis possible that the credit impact of anyunbundling could be negated through asustainable reduction of total debt and overallfinancial risk and/or a counterbalancing change instrategy that would lower business risk.Furthermore, the lower the proportionatecontribution of transmission networks to theconsolidated cash flow of the group, the lower theoverall impact of any unbundling. For example,

there was no impact on the ratings on Enel SpA(A/Watch Neg/A-1) when it sold down a minoritystake in Italian power transmission grid ownerTerna SpA (AA-/Stable/A-1+) in 2005, as Ternacontributed only 5%-6% of Enel’s thenconsolidated operating income. The degree ofheadroom in a company’s ratings could also havea bearing on the impact of unbundling if, forinstance, there is significant capacity within theratings for a weakening of the consolidatedfinancial and business risk profile.

Are competitively exposed utilities always ratedlower than network companies?No. For example, of the rated nonvertically integrated European utilities, Centrica PLC(A/Negative/A-1), which owns and operates generation and supply businesses, is rated higherthan National Grid PLC (A-/Stable/A-2), whichowns and operates the electricity and gas

UTILITIES


Company Country Business Model Transmission Corporate CreditAssets Rating*

Centrica PLC U.K. Generation and supply No A/Negative/A-1

E.ON AG Germany Vertically integrated Yes A/Stable/A-1

EDP - Energias de Portugal, S.A. Portugal Vertically integrated No A-/Negative/A-2

Electricite de France S.A. France Vertically integrated Yes AA-/Stable/A-1+

EnBW Energie Baden-Wuerttemberg AG Germany Vertically integrated Yes A-/Stable/A-2

Endesa S.A. Spain Vertically integrated No A/Watch Neg/A-1

Enel SpA Italy Vertically integrated No A/Watch Neg/A-1

Fortum Oyj Finland Vertically integrated No A-/Stable/A-2

Gaz de France S.A. France Vertically integrated Yes AA-/Watch Neg/A-1+

Iberdrola S.A. Spain Vertically integrated No A/Watch Neg/A-1

National Grid PLC U.K. Transmission and Yes A-/Stable/A-2distribution

Public Power Corp. S.A. Greece Vertically integrated Yes BBB+/Stable/--

RWE AG Germany Vertically integrated Yes A+/Negative/A-1

Scottish and Southern Energy PLC U.K. Vertically integrated Yes A+/Stable/A-1

Scottish Power PLC U.K. Vertically integrated Yes A-/Watch Neg/A-2

Suez S.A. France Diversified No A-/Watch Pos/A-2

Union Fenosa S.A. Spain Vertically integrated No BBB+/Stable/A-2

United Utilities PLC U.K. Combination utility No A/Watch Neg/A-1

Vattenfall AB Sweden Vertically integrated Yes A-/Stable/A-2

Veolia Environnement S.A. France Water No BBB+/Stable/A-2

*At Sept. 21, 2007.

Top 20 Rated European Utilities

transmission grids in England and Wales (as wellas some U.S. network assets). While Centrica hasa higher level of business risk than National Gridbecause its earnings are competitively exposedand are more volatile, this is compensated byCentrica’s significantly lower leverage. FollowingNational Grid’s recent acquisition of U.S.-basedKeySpan Corp. (A-/Stable/A-2), unadjusted netdebt will increase to approximately £19.5 billionby 2009, from £11.8 billion in 2007, withconsolidated funds from operations (FFO) interestcoverage of about 3.5x and FFO to total debt ofabout 15%. By comparison, in the 12 months toJune 2007, Centrica’s FFO coverage of adjustednet debt was very strong at about 97%.

Why would an ISO model have less of an impacton credit quality than unbundling?An ISO model in which the operationalmanagement and investment plans of transmissionnetworks would be controlled and determined byparties independent of the owners has beenpresented as an alternative--and potentially lesspolitically divisive--option than ownershipunbundling. The impact of such a move on theratings in the sector would in principle besignificantly less than that of unbundling, becausethe network owners would not be forced to divestand would retain access to the relatively solid,stable, and predictable network earnings(compared with, for example, volatile powergeneration earnings).

An ISO model would mean that the verticallyintegrated utilities--such as E.ON, RWE, EDF,EnBW, and Vattenfall--that own transmissionnetworks and whose credit quality benefits fromsuch ownership, would continue to own thenetwork and consolidate their earnings. Ratingrisk under an ISO model would, therefore, belimited compared with the significant rating riskpresented by ownership unbundling.

The ultimate effect of such a move woulddepend, however, on factors such as whether thenetworks would continue to be fully consolidated.In addition, current transmission network ownerscould decide to unilaterally sell networks if anISO system were introduced, thereby redeployingcapital from what would be a passive low-riskinvestment into a fully controlled and managedinvestment such as high-risk power generation.

What was the impact on Scottish Power andScottish and Southern Energy when the operationof their transmission networks moved to an ISO model?None. National Grid has operated thetransmission networks of Scottish Power andScottish and Southern Energy since 2005.

Both companies continue to consolidate theirtransmission networks, and their consolidatedcredit quality continues to benefit from therelatively stable earnings of the transmission networks. ■


UTILITIES

Publication Date:

0

100

200

300

400

500

600

700

800

900

1,000

oal il Natural as ydroelectric Nuclear

(Tons of 2equivalent gigawatt-

hours)

Carbon Emissions By Type Of Power Generation

Source orld conomic ouncil, 2004.


anada(24 )

ussia(19 )

Niger(16 )

ustralia(14 )

South frica(Nami ia)

(5 )

thers(23 )

The EU's Main Providers Of Uranium, 2006

Source uratom.



UTILITIES

Country Existing nuclear phase out legislation/policy State of debate

Belgium A 2003 law imposes the closure of nuclear plants after 40 The "Commission Energie 2030" in its years of operation--with exceptions possible for security of 2006 report recommended the reversal supply concerns--and prohibits the building of new nuclear of the nuclear phase out policy.plants. Gradual phase out planned to be completed in 2030, with first plant closure to occur in 2015.

Germany Based on the "Atomausstiegsgesetz" law, government and The German government's coalition nuclear operators agreed in 2001 to limit the average life agreement includes a clause statingof nuclear plants to 32 years based on production quotas. that there is no agreement on this The building of new nuclear plants is also prohibited. matter.

Spain Policy is to phase out nuclear power but no schedule or Policy of current government is to reduce specific strategy set. recourse to nuclear power without

compromising security of supply.

Sweden The "Nuclear Power Decommissioning Act" of January 1998 No decision on phasing out of nuclear allows the government to decide that the right to operate a power to be taken by current nuclear power plant will cease to apply at some point. Such government during term in office a decision infers the right to compensation from the state. (2006-2010).

Source: Standard & Poor's.

Table 2 - Nuclear Power Phase Out Policies In Europe

Limited Nuclear Revival In The EUNevertheless... Following the commissioning in September 2007of the Cernavoda 2 reactor in Romania, 146reactors are currently in operation in the EUproviding 30% of the region’s electricity.

Only four plants are currently being built andanother four are planned (see table 1). Thiscompares with 33 plants being currently builtworldwide and 94 planned. A number ofadditional nuclear plants are being considered inother EU countries, especially the Czech Republicand Finland as well as Lithuania and Romania,but with no firm commitment so far.

...Given Relatively Limited Political AndPublic Support So Far... Although the EU is generally supportive of thedevelopment of nuclear power, support at statelevel is more mixed.

Recognizing the right of each member state todecide on its energy mix, in March 2007 the EUCouncil underlined nuclear power’s place withinthe region’s carbon-reduction strategy, and itscontribution to addressing growing concernsabout security of supply. However, the councilalso highlighted nuclear power’s drawbacks interms of safety, decommissioning, and waste management.

Within the EU, some countries are clearlysupportive of nuclear power, especially France,Finland, and a number of Eastern Europeancountries. In The Netherlands, the government

signed the Borssele covenant in June 2006, underwhich the operating life of the country’s onlynuclear power station in Borssele has beenextended until 2033 at the latest, as long as itremains in the top quartile of the safest powerstations of its kind within the EU, the U.S., andCanada. In its May 2007 energy white paper, theBritish government also clearly reiterated itssupport for new nuclear power stations, the costsof which, including for decommissioning andwaste disposal, must, however, be entirely borneby the private sector.

Nuclear reactors

Under Operational construction Planned

France 59 1 0

Germany 17 0 0

Spain 8 0 0

Sweden 10 0 0

United Kingdom 19 0 0

Finland 4 1 0

Bulgaria 2 0 2

Romania 2 0 2

Slovakia 5 2 0

Others 20 0 0

Total 146 4 4

Source: World Nuclear Association, October 2007.

Table 1 - Nuclear Power Plants In the EU

educed(39 )

ncreased(14 )

on't know(13 )

aintained thesame(34 )

Eurobarometer: European And Nuclear Safety

Source uro arometer Fe ruary 2007 uropean and nuclear safety .


In your opinion, should the current level of nuclear energy as a proportion of all energy sources be reduced, maintained the same, or increased?

The risks outweighthe advantages

(53 )The advantages

outweigh the risks(33 )

Neither(spontaneous)

(6 )

on't know(8 )

Eurobarometer: European And Nuclear Safety

Source uro arometer Fe ruary 2007 uropean and nuclear safety .


When you think about nuclear power, what first comes to mind?


• For TVO, a strong turnkey, time-certain supply contract with ample guarantees, backed by strong suppliers and security bonds in the construction phase, as well as by offtake agreements with its main shareholders during the operation phase.

• For EDF, during the construction phase by the group’s expertise in building nuclear plants, its last such plant in France having been commissioned in 2002, and by the group’s leading domestic position and the protective French regulatory environment inthe operation phase.

• For the Slovakian plants by the strong support of the government, which owns 34% of SE.

From a financial perspective, both EDF andEnel have the financial flexibility to carry out theinvestments necessary for their new builds of,respectively, € 3.3 billion and $2.2 billion. TVO ismuch smaller, but the protective turnkey contractand the offtake arrangements with its majorshareholders provide substantial comfort.

That said, in August 2007 we revised tonegative the outlooks on Estonia-based integratedelectric utility Eesti Energia AS (A-/Negative/--)and Lithuania-based electricity transmissioncompany Lietuvos Energija (A-/Negative/A-2) toreflect the risks stemming from their possibleparticipation in a prospective new nuclear powerplant at Ignalina, Lithuania.

The Ignalina nuclear project is based on a 2006agreement between the governments of Lithuania,Estonia, Latvia, and, at a later stage, Poland.However, realization of the project, includingfunding, will be the responsibility of theparticipating state-owned power companies. EestiEnergia could participate in the nuclear projectwith a 22% stake, while Lietuvos Energija wouldhave a 34% stake and would be responsible forthe plant’s operations. The nuclear power plantwould have maximum installed capacity of 3,400MW at a projected cost of up to €4 billion.

Extension Of Existing Plants Would BeCredit PositiveA number of EU nuclear operators are seeking toextend the operating life of their plants drawingon the U.S. example, where at the end of 2006,47 licenses extending the operating life of nuclearplants to 60 years had been granted and an

additional eight were being reviewed. In the U.K., British Energy Group PLC (BE;

BB+/Watch Neg/--) obtained approval in 2005 fora 10-year extension of its Dungeness plant. In2008, BE may apply to extend the lives of itsHinkey Point and Hunterston plants, which arecurrently scheduled to close in 2011. Extendingthe operating life of its nuclear plant beyond thecurrent 40 years is also a key pillar of EDF’sstrategy. Czech operator CEZ a.s. (A-/Stable/--),has also launched an upgrade program at itsDukovany nuclear plant, with a view toincreasing capacity by 160 MW and extendingoperating life by up to 20 years. AlthoughSwedish utilities have not applied for lifeextensions they have obtained approval foruprates (capacity increases), which willsignificantly boost their nuclear capacity: Upratesunderway and planned between 2006-2011 at theRinghals plant, which is operated by VattenfallAB (A-/Stable/A-2), will increase its capacity byclose to 500 MW. The group will also boostcapacity at its other nuclear plant, Forsmarks, by410 MW between 2008-10. E.ON Sverige AB(A/Stable/A-1) is also planning a 250 MW uprateof its Oskarshamn-3 reactor, to increase itscapacity to 1,450 MW.

We view such extensions very positively as,while running, nuclear power plants are highlycash generative in light of their low variable costsand limited capital expenditures for maintenance.Such extensions also delay decommissioningliabilities and capital expenditures for capacity replacement.

Conversely, New Nuclear Build IsInherently Risky Building new nuclear plants is challenging given:

• Long lead times with no offsetting revenue. EDF Energy PLC (A/Stable/A-1), which is interested in building four new nuclear plants in the U.K., believes that the earliest such a plant can be commissioned is 2017.

• High upfront capital costs (about € 3 billion), with the risks of delays overruns, especially for “first of a kind” plants. The TVO plant in Finland is now about two years late and has experienced very substantial cost overruns.

Such features are specific to nuclear powerplants, conventional power plants having muchshorter lead times and much lower capital costs.

UTILITIES


Conversely, conventional power plants are muchmore exposed to the vagaries of fuel prices.

New nuclear plants also represent largecapacity increases in one step (the new Frenchand Finnish plants both have 1,600 MWcapacity), whereas incremental capacity additionsare better suited to deregulated markets.

Operational Inflexibility Is A Drawback In A Competitive Environment In operation, nuclear plants’ low operating costsand lack of carbon emissions are key competitiveadvantages. Yet operational inflexibility partiallyoffsets these benefits, with nuclear plant operatorslimited in their ability to alter output in responseto fluctuating energy demands, which weakenstheir market position. Nuclear plants providebase-load power and are, therefore, price takersrather than price setters. This is a significantdrawback in today’s largely unregulated markets, which are characterized by volatile demand patterns.

The risks of investing in new nuclear power stations are mitigated to a degree by theEU’s rapidly declining capacity margin and the resulting substantial investments in powergeneration required to meet the growth indemand and planned power plant decommissioning.

Moreover, only the largest EU utilities will beable to invest significantly in new nuclearcapacity. These groups all have large customerbases as well as a diversified generation mix--except EDF, which has a quasi-exclusive focus onnuclear power but benefits from the protectiveFrench environment--and extensive experience inrunning nuclear plants. What is more, to mitigaterisks they may chose to expand, especiallyabroad, through partnerships, and/or to enter intoofftake agreements.

The large European utilities are likely to investboth in their own markets--if nuclear phase-outagreements are revised--but also abroad. EDF andthe German utilities have highlighted their interestin new nuclear builds in the U.K., while five

groups--Electrabel, which is part of Suez S.A. (A-/Watch Pos/A-2), CEZ, E.ON AG (A/Stable/A-1), Enel, and RWE AG (A+/Negative/A-1)--haveplaced indicative bids for an up to 49% stake inthe Belene nuclear power plant project inBulgaria. Likewise Enel, Electrabel, Iberdrola S.A.(A/Watch Neg/A-1), RWE, and CEZ have bid toparticipate in the construction of reactors 3 and 4in Romania at Cernavoda. Only EDF appearsinterested in investing in nuclear projects outsideof Europe. It is focusing on the U.S., China, andSouth Africa. EDF recently announced anagreement with U.S. utility Constellation EnergyGroup Inc. (BBB+/Negative/A-2) to set up a 50/50joint venture to build, own, and operate Europeanpressurized reactors (EPRs) in the U.S.

In the short term, we expect investments innuclear power by EU utilities to increase onlygradually, reflecting the long lead time for newnuclear projects and the time needed to build uppolitical and public support. Investments innuclear power are therefore unlikely tosignificantly weigh on ratings. Risks may increasein the medium term as investments in nuclearpower rise, though. The pace of such investmentsand the context--the degree of competitiveness ofpower markets, share of generation to be derivedfrom nuclear power, life extensions of existingnuclear plants, level of expected wholesale andcarbon prices, and political environment--inwhich they are carried out, will be key to ourassessment of any rating impact. As a rule ofthumb, we are likely to consider too strong anexposure to nuclear power in an open market as risky.

We expect most investments in nuclear powerto be on balance sheet, given the financialfirepower of major European utilities, thedifficulty of nonrecourse funding of such projectsin light of the risks entailed, and the difficulty ofreplicating alternatives approaches such as TVO’s mixed-ownership structure, whichencompasses both utilities and electro-intensive industrial groups. ■

UTILITIES

Publication Date:

osenergoatom(state nuclear

monopoly)(16 )

ther producers(14 )

S(70 )

ussia's Power Produ tion Mar et 2006

Source S of ussia.



and its subsidiaries. The majority of the newgencos are still UES subsidiaries but are likely tobe privatized in the short term.

Some observers refer to UES’ new investmentprogram as ‘GOELRO-2’ (the first GOELRO wasthe original Soviet plan in 1920 for nationaleconomic recovery and development). GOELRO-2 envisages heavy investment in new generationcapacity, which should result in an additional 34gigawatts (GW)--the equivalent of 16% of thecurrent national generation capacity--by 2011.The investment plan relies heavily on externalequity and debt financing, and consequently most gencos are tapping the equity and debtcapital markets (see map above and table 1 onnext page).

The reform plan stipulates that the privatizationof all thermal generation will take place during2007-2008 through IPOs, secondary publicofferings, sales of equity stakes owned by UES,and the allocation of the remaining stakes to UESshareholders at the end of UES’ restructuring,scheduled for mid-2008. Between December 2006and October 2007 generating companies WGC-3,WGC-4, TGC-1, TGC-8, and Mosenergo (AO)(BB/Stable/--; Russia national scale rating ‘ruAA’)completed share issues, and WGC-5 and TGC-5were spun off, resulting in UES’ equity interest

falling below 50%. Many of the gencos remainingunder control of UES already have a strategicminority investor that is looking to acquire acontrolling stake through participation in IPOsand stake auctions. Strategic investors includemajor Russian industrial groups, coal and gasproducers, and major European utilities andinvestment funds.

The Russian government, however, is likely toremain the largest player in the power sector: Itwill retain all of Russia’s nuclear generationcapacity through Rosenergoatom, most of thehydro generation capacity through Hydro-WGC,and a significant portion of thermal generationcapacity through OAO Gazprom (BBB/Stable/--)and InterRAO UES (not rated). Gazprom, whichcontrols Russia’s gas reserves and pipelines and isan important fuel supplier to the electricitygenerators, has recently underscored itsinvestment ambitions in the electricity generationsector by acquiring major stakes in Mosenergoand TGK-1 and negotiating a swap of its 10.5%stake in UES for controlling stakes in OGK-2 andOGK-6. Gazprom is also playing a leading role inthe creation of a joint venture with coal producerSUEK, which might receive most of Gazprom’sand SUEK’s generation assets.

Standard & Poor’s views the change of the

Russian Energy Production

UTILITIES


Share of national

GW total (%) TWh (%) (%)

Rosenergoatom 23.2 11 154.7 76 Nuclear 0 Russian Federation

Hydro-WGC 21.7 10.3 74.6 39 Hydro 100 Russian Federation

Irkutskenergo 12.9 6.1 57 50 Hydro, 0 UC RUSALCoal shareholders

TGC-3 10.5 5 64.4 70 Gas 36 Gazprom

WGC-1 9.5 4.5 47.2 57 Gas 92 N.A.

WGC-6 9.1 4.3 32.9 42 Gas, 93 GazpromCoal

WGC-2 8.7 4.1 48.1 63 Gas, 65 GazpromCoal

WGC-5 8.7 4.1 40.4 53 Gas, 0 EnelCoal

WGC-4 8.6 4.1 51 68 Gas, 29 E.ONCoal

WGC-3 8.5 4 30.6 41 Gas 37 Norilsk Nickel

Tatenergo 7 3.3 24.9 40 Gas 0 Republic of Tatarstan

TGC-7 6.9 3.3 27.2 45 Gas 54 Gazprom, IES

TGC-1 6.1 2.9 23.6 44 Gas, 14 GazpromHydro

Far Eastern Generation 5.8 2.7 21.5 44 Coal 48 Russian FederationCompany

Bashkirenergo 5.1 2.4 25 56 Gas 21 N.A.

TGC-9 4.8 2.3 20.1 48 Gas 50 IES

TGC-5 3.8 1.8 12.5 37 Gas 0 IES

TGC-12 3.6 1.7 19.9 63 Coal 49 Gazprom/SUEK

Prosperity CapitalManagement

TGC-4 3.3 1.6 13 45 Gas 47 Transnafta, CEZ,Korea Electric

Power Corp

TGC-8 3.3 1.6 15.3 53 Gas 11 IFD Kapital

TGC-6 3.1 1.5 13.2 48 Gas 50 IES

Novosibirskenergo 3 1.4 14.3 55 Coal 14 N.A.

TGC-10 2.6 1.2 16.8 73 Gas, 82 Gazprom, E.ONCoal

TGC-13 2.5 1.2 10.4 48 Coal 57 Gazprom/SUEK

InterRAO UES 2.3 1.1 N.A. N.A. Gas 60 RussianFederation/Rosenergoatom

TGC-11 2 1 8.4 47.1 Gas, 100 GazpromCoal

TGC-2 1.4 0.7 6.4 52.7 Gas 49 Prosperity CapitalManagement

TGC-14 0.6 0.3 2.8 49.9 Coal 50 Norilsk Nickel

GW--Gigawatts. WGC--Wholesale generation company. TGC--Territorial generation company. N.A.--Not available. Source: RAO UES of Russia, media,corporate filings, and Web sites.

Electricity production

(full-year Capacity UES Strategic (potential)Installed capacity 2006) factor Fuel holding investor

Table 1 - Russian Energy Producers’ Statistics

UTILITIES


UTILITIES

controlling owner as a major credit risk factor in2007-2008 for thermal gencos due to the impacton business strategy, operational profile, andfinancial policy. The level of actual or impliedsupport from the new owner is anotherconsideration. The credit quality of gencos maytherefore diverge substantially, with that of someimproving and others weakening.

Gencos may benefit from becoming part ofdiversified, vertically integrated energy groups andfrom ownership changes, if, for example, theythen have better and cheaper access to fuelsupplies, as well as financial support from thenew owners. Any new controlling owner could,however, pursue a more aggressive financialpolicy, including higher debt leverage and higherdividend payouts to raise equity returns. Creditorsof companies whose strategic investor is a largecustomer or fuel supplier also face the risk thattransfer pricing may eliminate any benefits ofhigher wholesale power prices following pricederegulation, if the corporate governance at newgeneration companies is not effective enough tobalance the inherent conflicts of interest.

UES intends to limit the strategic discretion ofnew owners by retaining minority stakes afterprivatization, shareholder agreements with newcontrolling owners, and contracts for generationcapacity availability. Although these measuresmay reduce strategic risk, they create newchallenges such as burdensome fines for delayeddelivery of contracted capacity. This is likely tohappen given the high construction risk inherentin all greenfield power projects and the risk thatexternal funding or necessary equipment may be unavailable.

After Privatization, More Consolidation?Increased M&A is likely to follow the gencos’privatization and become an important credit riskfactor. We expect that the new controlling ownerswill employ asset consolidation, asset swaps,restructuring, and divestments to align theirholdings with their business strategies. This isbecause, first, many strategic investors havedemonstrated an interest in acquiring more thanone generation company, as well as assets in otherbusiness segments such as electricity distributionand supply. These may be consolidated into oneentity within existing unbundling requirements.Second, the government determined the currentconfiguration of gencos with the primary purpose

of creating a fair competitive landscape, whilebusiness logic may favor other assetcombinations. Third, current UES shareholders,who will receive proportional stakes in the gencosand grid companies after liquidation of the UESholding, are likely to attempt to swap relativelysmall holdings for larger and more influentialstakes in successor gencos and grid companies,giving additional impetus to M&A.

The credit impact of post-privatization M&Amay be both positive and negative depending onthe credit quality of combined entities, thebenefits of vertical integration, the synergiesderived from new business combination, and theimpact of transactions on the new entity’sconsolidated financial profile.

Vertical integration might underpin generators’business profiles One of the main aims of the Russian power sectorreform is to unbundle each business segment inthe electricity value chain--generation,transmission, distribution, and supply--to makeeach more competitive, gain efficiency, andimprove the regulatory regime’s transparency. So,wholesale generation companies (WGCs) andterritorial generation companies (TGCs) have onlygeneration operations in the electricity supplychain. We believe that deregulated, unbundledgeneration has relatively high business riskcompared with other operations in the valuechain. This is because of the high level of capitalintensity; the commodity nature of the industry,with price-based competition, high exposure toother commodity prices (for example, fuel), orfluctuation of water resources; and high levels of competitive risk compared with transmissionand distribution operations, which are natural monopolies.

After unbundling, we expect Russian gencos tofocus their strategies on business riskdiversification by vertically integrating lower-riskregulated businesses segments and fuel and retailelectricity supply operations. A similar approachis already taking place as fuel supply companieslook to invest in power generation to unlock thebenefits of vertical integration of power and fuelproduction and supply. Non-governmentcontrolled electric utilities, such as Irkutskenergo,AO EiE (B+/Positive/--; Russia national scalerating ‘ruA’), have shown a similar strategic intentby acquiring coal mines (to hedge fuel price and


supply risk) and obtaining control of municipallyowned electricity and heat distribution networks(to provide a base of stable, network earnings andimprove operations). However, the potentialdegree of diversification is limited by the legalprohibition of simultaneous ownership of“monopoly” (transmission, electricity distri-bution, and dispatching) and “competitive”(generation and supply) assets within one marketprice zone. The two power market zones areEurope and the Urals, and Siberia. This lawprohibits the vertically integrated generation anddistribution structures typical of European power utilities.

Diversification, the potential synergies, andhedging opportunities should support the interestof gencos and their strategic minority investors toinvest in supply companies, all of which UESplans to sell in 2007-2008. A combination ofwholesale generation and supply should reduceoverall business risk through diversification of thecustomer base and higher customer loyalty. This islikely to result in lower competitive pressure andreduced customer attrition, as well as highermargins in retail electricity sales. At the sametime, on their own, electricity supply operationshave the highest business risk in the electricityvalue chain.

A Whole New Wholesale System In September 2006, Russia introduced new rulesfor its electricity market that are a big steptoward full deregulation of wholesale power. Inplace of the old regulated pool system, wheregenerators sold power at cost-based rates andreceived regulated payments for fixed capacitycosts, the new market is based on bilateralregulated contracts between generators andwholesale customers, which initially covered 95%of planned generation volumes. Generators sellany volumes not covered by regulated contracts,and customers sell any surplus power fromregulated purchases on the deregulated spotmarket. Actual supply/demand dynamicsdetermine the deregulated market’s share.

The government intends to deregulate themarket and reduce volumes sold under regulatedcontracts. In April 2007, it approved a newderegulation plan that would fully evolve from2007 to 2010 (see chart 3). This is well ahead ofprevious plans that had a seven- to 20-year time frame.

The contracts have “take-or-pay” terms (that is,buyers will make payments to the electricitywholesaler for the contract electricity volumeregardless of their actual power demand). Since2008, the contracts will also have an automaticadjustment for passing fuel costs on to customersand an annual adjustment to regulated rates forother increasing costs through an inflation-based formula.

In the new market model, a generator alsorecovers fixed costs through regulated bilateralcontracts. The government plans to deregulatecapacity payments in line with the spot market byreducing the portion of generation capacitycovered by regulated payments. Wholesale marketparticipants will have to procure capacitycovering their peak demand, minus capacity paidthrough regulated contracts from generatorsthrough a market-based mechanism. The firstauction is likely in 2007 for capacity to bedelivered in 2008 and 2012.

Exposure to spot price volatility will grow in linewith market deregulationSeasonal, daily, and intraday power-demandvariations make spot electricity prices highlyvolatile (see chart 4 on next page). While gencos’current exposure to the spot price is limitedbecause only 10% of the wholesale market hasbeen opened, this exposure will increase in linewith wholesale market deregulation and willreach 100% by 2011.

Spot-price deregulation for generators inEuropean Russia and in the Ural region has beenpositive to date (see chart 5 on next page).

UTILITIES

Chart 3Russian Wholesale Market

Deregulation Schedule

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( )( h)

verage deregulated price(left scale)

verage regulated price(left scale)

Spot sales as percentage of total(right scale)

ont ly A era e Spot Electr c ty r ce European u a And e ral

Sept.2006

ct.2006

Nov.2006

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ar-07

pr-07 ay-07

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-- u le. h-- egawatt-hour.


0

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uly 1,2010

( per tcm)

-- u le. tcm--Thousand cu ic feet. Source ussian Federal Tariff Service.


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ct.2006

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pressure on market prices. However, new plantscan’t be built quickly, so it will take some time toease this capacity constraint.

Higher profitability from increased power priceswill underpin generators’ business profileAs seen in Western Europe, moving fromregulated cost-plus regimes to a deregulated spotelectricity market typically increases generators’business risk and can often dilute credit quality.Standard & Poor’s believes that the new path toderegulation might support improved creditquality in the sector through higher transparencyand price growth, while capacity payments andhedging will smooth the impact of volatile spot prices.

The deregulated market will translate rising gasprices into higher electricity prices, reflecting thecosts of the least efficient (marginal) gas-firedgenerators for all market players. Generators using other fuels such as coal, nuclear, hydropower would consequently reaphigher margins, as would more efficient gas-fired producers.

We expect the higher profitability to mitigateincreased price volatility because stronger marginswill cushion the impact on cash flow. This willsomewhat offset price deregulation’s negativeimpact on cash flow stability. Generationcompanies’ profitability is currently low, with anaverage 10% EBITDA margin for UES and a tiny1%-2% for some thermal generators. Despitemost electricity being sold at regulated tariffs,relatively small changes in price or fuel costs--together with weak margins--result in substantialcash flow fluctuation. That implies high business risk.

Political risk remains key to power pricederegulation and growthPolitical risk, however, overshadows the rosyprospects for power generators in the new marketderegulation plan. Customers will bear substantialprice increases and could face soaring electricitybills in the next three to four years, potentiallyleading to a political backlash. In addition, mostof the market deregulation and correspondingprice increases are scheduled for 2009-2010. Butthis comes after the 2008 presidential elections,when Russia will have a new president who mayhave different views on electricity price policy andperhaps even on the sector’s overall strategy.

Generators’ active hedging strategies couldprovide further cash flow stabilityAfter the wholesale market is fully deregulated,each generator’s decision on how to balancepotentially profitable but volatile opportunitiesfrom spot sales in order to lock in a more certainlevel of profits will determine its spot-marketexposure. More forward electricity sales at a fixedprice that allows the generator to earn sufficientprofits to support its credit quality (assuming thatgeneration costs are also fixed) would imply alower business risk. Generators currently canhedge price volatility through nonregulatedforward contracts at a fixed price. Powerexchanges plan to introduce other instruments,such as power futures, to expand hedgingopportunities. Thus, a conservative hedgingstrategy would limit the impact of changes in spotprices on cash flow volatility in the coming one totwo years.

How capacity market contracts could helpThe proposed capacity market, a system ofpayments to generators that cover fixed costs, willalso mitigate the impact of spot price volatility oncash flow stability.

Standard & Poor’s believes that recoveringfixed costs through the capacity market willunderpin generation companies’ credit quality.Capacity payments, now accounting for aboutone-half of wholesale generation revenues,substantially reduce the operational ‘gearing’ (thelevel of fixed operating costs that determines thedependence of operating income variability onsales variability) of generators. These paymentsaren’t common in other European generation markets. The still-to-be-determined capacitypricing mechanism will heavily influence the levelof market-based capacity payments andgenerators’ profitability and cash flow. The finalmechanism expected in 2007-2008 will reducethis uncertainty.

Who will benefit from market deregulation?The competitiveness and profitability of gencos inthe deregulated market depend heavily on theirmarginal cost position. The main factor forgencos is fuel costs and for hydro generators,water tax charges.

Deregulation of the electricity market will resultin a gradual transition of the average electricityprice from regulated tariffs that reflect costs to a

UTILITIES

0100200300400500600700800900

osen

ergoa

tom

idro

( urope

)

T-1

T-10

-4( uro

pe)

nter

S

T-3

(os

energ

o) -2T

-5 -5 -1

Taten

ergoT

-8T

-7T

-6

Bashk

irene

rgoT

-9T

-4

-3( uro

pe)

-6( uro

pe)

T-2

( per h)

verage regulated electricity tariff for 2007verage spot electricity price an.-Sept. 2007

era e e ulated Electr c ty ar ff And Spot r ce n European u a aSept



050

100150200250300350400450

rkutsk

energ

o

T-13

-4(Si eri

a)

-6(Si eri

a)

T-12

Novos

i irske

nergo

thers

(Si eria)

-3(Si eri

a)

T-11

T-14

( per h)

verage regulated electricity tariff for 2007verage spot electricity price an.-Sept. 2007

ra e e ulated Electr c ty ar ff And Spot r ce n S ber an u a an S




UTILITIES

Table 2 - Russian Thermal Generation Companies’ IFRS Financial Statistics

(although for some companies, very weak cash flow results in poor cash flow protectionmeasures).

In the next three to four years, the gencos’ debtlevels are likely to grow substantially. This is aresult of the sector’s heavy capital-investmentneeds to replace capacity that’s reaching the endof its productive life, to add capacity for demandgrowth, and to maximize returns for privateshareholders. UES expects the financing of thehuge investment program (which UES hasestimated to be RUR1.45 trillion over the period)to result in significant borrowing by gencos of upto RUR400 billion-RUR500 billion.

In 2007-2008, however, equity financing cancover the majority of external funding needs. Forexample, UES has set an ambitious target to raiseas much as $17 billion in equity financing.

Gencos are therefore generally likely to relymore on equity financing in 2007-2008, with

most of the debt hitting in 2009-2010. By thattime, electricity market deregulation and likelyprice increases should have improved the gencos’profitability and operating cash flow, and helpedto mitigate increasing debt levels.

While the proceeds from the share issues andsales in 2007 have been above expectations, theavailability of equity financing that UES expectsin 2007-2008 is subject to general capital marketconditions, as well as investor perceptions of therisks involved. Those risks may be subject tochange, and so the ability of UES and the gencosto meet the target is uncertain. If proceeds fromequity sales fall below expectations, additionalborrowing may be needed--assuming lenders arewilling. Of course, such borrowing could weakenthe gencos’ credit quality. If financing isn’tavailable, the investment program would need tobe scaled back and delayed.

(RUR mil.) Mosenergo HydroOGK OGK-5 OGK-1 OGK-2 OGK-3 OGK-4 TGK-1 TGK-5 TGK-12

Period 12 months 2006 12 months 2006 2006 2006 2006 2006 2006 2006ended ended

June 30, June 30,2007 2007

Total revenues 67,336 24,468 26,081 30,062 25,433 23,070 26,110 21,594 11,402 19,637

Funds from operations (FFO) 4,738 4,942 2,729 2,105 (28.0) 386 1,720 441 476 2,252

Capital 18,853 15,532 5,578 1,738 826 1,265 1,092 3,372 512 1,249expenditures

Cash and investments 50,483 6,768 11,925 549 1,720 355 778 650 132 271

Debt 17,722 17,179 5,089 1,622 5,737 3,704 1,023 6,397 868 1,254

Common equity 135,963 81,868 50,071 23,708 13,075 15,256 22,436 24,595 10,400 15,874

Total capital 153,685 120,033 55,159 25,330 18,812 18,960 23,459 30,991 11,267 17,128

Adjusted ratios

FFO interest 3.2 13.8 6.9 20.2 0.8 2.6 10.7 2.0 14.0 6.8 coverage (x)

FFO/debt (%) 26.7 28.8 53.6 129.8 (0.5) 10.4 168.1 6.9 54.9 179.6

Operatingincome (bef. D&A) / sales(%) 11.7 28.1 11.0 10.4 1.5 4.7 8.7 9.6 8.4 11.3

Return on capital (%) 2.0 3.8 1.5 8.2 (3.5) 0.0 3.7 2.3 5.1 3.9

Debt to capital (%) 12.0 14.0 9.0 6.0 30.0 20.0 4.0 21.0 8.0 7.0 RUR--Ruble. D&A--Depreciation and amortization.


Investor Rating Investment Timing Cost

E.ON AG A/Stable/A-1 60.7% in WGC-4 Oct. 2007 $5.9 bil.

Enel SpA A/Watch Neg/A-1 29.9% in WGC-5 June 2007 $2.2 bil.

Enel SpA A/Watch Neg/A-1 49.5% in Rusenergosbyt 2006 $105 mil.(supply company)

Fortum Oyj A-/Stable/A-2 25.5% in TGC-1 2003-2005 N.A.

N.A.--Not available.

Table 3 - European Investments In The Russian Power Industry

UTILITIES

Why Russia Is Tempting For EU Power Utilities The fast-growing Russian power sector and itsongoing liberalization present a particular lure forWestern European utilities. The industry predictsthat the sector will grow at about 5% over thenext few years and that it will need investments ofmore than $20 billion per year over the next 15years to modernize power stations andtransmission systems and to construct newgeneration capacity.

The restructuring and liberalization process thatRussia is now undergoing is similar to what hasoccurred in the EU over the past seven or eightyears. European companies such as E.ON AG(A/Stable/A-1), Enel SpA (A/Watch Neg/A-1), andFortum Oyj (A-/Stable/A-2) have therefore gainedvaluable experience domestically and in otherEastern European countries that they canpotentially transfer to Russia. This includesmanaging operating and capital costs, as well asregulatory and network risks in liberalizedmarkets. In addition, new entrants can bringtrading and hedging expertise to mitigate thecommodity and power-price risks that arecharacteristic of liberalized power markets.Leveraging these skills is one way for theEuropeans to add value to the sector. Indeed,several major European utilities have alreadymade large investments in Russia’s power industry(see table 3).

As Russian utilities have so far been state-controlled companies, could find opportunities toimprove efficiency. Up until now, the Russiantariff system has often been based on costrecovery, so that remuneration earned on assetsdepends on a cost-plus system that allows areturn on reported costs, leaving no greatincentive to improve efficiency. However, smaller,privately owned generation utilities have beenvery successful in cutting costs.

European utilities will have to guard againstcredit dilutionInvestments in the Russian power sector wouldgenerally dilute credit (as would most investmentin Eastern Europe), owing to Russia’s greatermacroeconomic, sovereign, and country risks. TheRussian economy is less diversified and may beless stable over time, the political system may besubject to change, and the regulatory system isless mature, all of which creates regulatory andpolitical uncertainty. These risk factors translateinto a weaker business profile for Russian powerutilities compared with Western European peers.Therefore, the average credit quality of Russianand Eastern European power companies is lowerthan that of EU power companies.

The ratings on Russian utilities are belowinvestment grade, in the ‘BB’ or ‘B’ category,because the companies are smaller, less diversified,and less profitable than Western European peers.They generate less or no free cash flow and facegreater political, legal, and regulatory risks thanutilities in the EU. By contrast, more than 90% ofEU utility ratings are rated in the investment-grade rating categories (‘BBB’ or higher).

Although investments in Russia would dilutecredit quality, we would expect EU utilities tomanage the rating risk by proactively managingtheir exposure. Western European companies suchas Germany’s E.ON or Italy’s Enel are large,diversified companies with relatively strongbalance sheets. We don’t expect the share offuture consolidated earnings and investment fromRussia to represent a concentration risk. Weexpect the same to be true for smaller companiessuch as Czech Republic-based CEZ a.s. (A-/Stable/--) or Nordic utility Fortum, which alsoregard Russia as a target market. Other largeacquisitions, however, such as Enel’s planneddebt-financed purchase of Spanish power utilityEndesa S.A. (A/Watch Neg/A-1), could lowerratings and debt capacity for Russian investment.


The ultimate impact of any Russian investment onthe credit ratings of a company depends onseveral factors. Among them are its size, whetherit represents a majority interest that would beconsolidated or a minority investment that wouldbe accounted for using the equity method, how itis funded, its earnings and cash-flow visibility,and how much headroom is in the current ratingsto absorb such an investment.

Better Credit Quality Likely, But RegulatoryRisk RemainsOverall, the restructuring of UES andderegulation of the power prices may supportimproved credit quality in the sector throughlower business risk strategies, higher transparency,and price growth, while capacity payments andhedging will smooth the impact of volatile spotprices. The downside is that customers will likelyface much higher electricity bills in the next threeto four years and political and regulatory riskswill remain a key challenge for credit quality inthe sector. ■

UTILITIES


COMBATING CLIMATE CHANGE IN THE EU: RISKSAND REWARDS FOR EUROPEAN UTILITIES

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Climate policy is a key high-level issue forthe EU and its member states. Indeed, theEuropean Council, the EU’s main decision-

making body, recently reaffirmed its commitmentto the reduction of carbon dioxide (CO2) andother greenhouse gases (GHGs). It recommendedthat the Emissions Trading Scheme (ETS), whichis the EU’s principal policy instrument for hittingits emissions targets, be strengthened andbroadened in scope. As a result, the ETS--andother climate policy initiatives such as the drive toincrease the share of GHG-clean renewableenergy in the energy mix--will continue to have amajor impact on European electricity generatorsand vertically integrated utilities that Standard &Poor’s Ratings Services rates. That’s because theburning of fossil fuels such as coal, oil, and gas togenerate electricity accounts for a very significantshare of EU GHG emissions (see footnote at endof article). The most visible effect of the ETS todate has been through an increase in powerprices, as fossil fuel generators in liberalized(deregulated) markets now include the cost ofCO2 emissions in their pricing decisions. Weexpect the ETS to potentially have a greaterimpact on power prices in Phase 2 of the ETS(2008-2012), as the cap on CO2 emissions will be tighter.

Until the form of any potential successor treatyto the Kyoto Protocol (an agreement made underthe UN Framework Convention on ClimateChange that requires industrialized signatorynations to collectively reduce GHG emissions)becomes known, European utilities lack visibilityon the scope and potential impact of globalclimate change policies beyond 2012, when Kyotoexpires. The European Council’s decision inMarch 2007 to adopt either a 20% or 30% GHGreduction target by 2020, depending on the scopeof any successor treaty to the Kyoto Protocol,reflects this uncertainty. Nevertheless, it is clearthat GHG emission reduction will continue to becentral to EU policy over the long term and thatthe operating and regulatory environment forelectricity generators will remain influenced bythis focus.

In considering the effects of climate changepolicy on European utilities, we examine theimpact of the ETS on power prices and on theprofitability of the power generation sector. Wediscuss the challenge for generators in takinglong-term investment decisions given the high

level of uncertainty about future policy, thepossible roles that renewable and nuclear energywill play in the generation mix, and whytechnological developments will be key to thefuture of coal-fired generation.

High Power Prices Under The ETS: BenefitsFor Some, Rising Costs For OthersThe principal impact of EU climate changepolicies has been a continued boost in theprofitability and cash flows--and therefore creditquality--of European generation companies thatoperate in countries in which wholesale and retailpower markets and prices have been fullyliberalized. The key instrument of these policieshas been the ETS.

The ETS restricts CO2 emissions and requirespower generation and energy-intensive companiesin what are known as the “covered sectors”(encompassing oil refineries; coke ovens; iron andsteel plants; and factories making cement, glass,lime, brick, ceramics, and pulp and paper) to holdtradable allowances to match their CO2emissions. The covered sectors account for about50% of total EU GHG emissions. The ETS beganon Jan. 1, 2005, and Phase 1 will run until Dec.31, 2007. Phase 2 will run from January 2008 toDecember 2012, the period over which theperformance of the Kyoto signatory nationsagainst their GHG emission reduction targets willbe assessed.

The impact of the ETS on the power generationand energy-intensive industrial sectors differsmarkedly. While both power generators andenergy-intensive industrial power users face capson CO2 emissions and have been granted freeallowances to at least partly cover their emissions,it is the power generators that benefit from higherpower prices, at the expense of electricity users.

One of the foremost effects of the ETS has beento increase wholesale power prices in marketssuch as the U.K. and Germany in which fossilfuel-fired generation is the marginal price-settingplant. Electricity generators that burn fossil fuels--coal, lignite, gas, and oil (fossil fuel-basedgeneration accounts for about 50% of EUgeneration)--include the cost of CO2 emissions intheir cost base and pricing decisions. All otherthings being equal, the higher the price of CO2allowances, the greater the impact on powerprices. EU fossil fuel power generators that emitCO2 receive “free” allowances, however, under

Publication Date:

May 10, 2007

Primary Credit Analyst: Peter Kernan, London, (44) 20-7176-3618

Secondary Credit Analysts: Michael Wilkins, London, (44) 20-7176-3528

Mark Schindele, Stockholm, (46) 8-440-5918

Hugues De La Presle, Paris, (33) 1-4420-6666


UTILITIES

their respective governments’ national allocationplans (NAPs). These plans are vetted andapproved by the EU. Allowances for Phase 1 arealready known, while Phase 2 allowances arecurrently being finalized. Even though a generatorwill have received free allowances to cover itscarbon emissions, it will still price emission costsas if it had purchased the allowances from themarket, leading to higher wholesale prices. Formany generators, these higher wholesale pricesdrop directly to the bottom line as windfallprofits, either because the allowance was neverpurchased or because the generator (nuclear andhydro plants, for example) does not emitgreenhouse gases. Companies currently benefitingfrom windfall profits are those operating in theU.K., German, and Nordic electricity markets,and include E.ON AG (AA-/Watch Neg/A-1+),RWE AG (A+/Negative/A-1), EnBW EnergieBaden-Wuerttemberg AG (A-/Stable/A-2),Vattenfall AB (A-/Stable/A-2), Scottish andSouthern Energy PLC (A+/Stable/A-1), ScottishPower PLC (A-/Watch Neg/A-2), and EDF EnergyPLC (A/Stable/A-1).

Approved NAPs indicate a tighter market inPhase 2 of the ETSThe European Commission has now decided onthe first 20 national plans for allocating CO2emission allowances to energy-intensive industrialplants and the power sector for Phase 2 of theETS (see table on next page). Seventeen of the 20member states were told to reduce proposedallowances by almost 12.5% on average, whileallowances for the U.K., France, and Sloveniawere approved as presented (the adjustment toSpain’s proposed cap was negligible). To date, theoverall cap allowed by the EU for Phase 2 isabout 9% lower than the cap allowed for Phase 1.It is likely the electricity generation companieswill take a significant share of this tighteningthrough a lower allocation of free allowances inPhase 2. From an equity standpoint, the electricitygeneration companies may be best positioned toabsorb a lower level of allowances given that theybenefit from higher CO2-induced power priceswhile industrial and residential power users bearthe cost.

The tightening in Phase 2 could lead to strongerCO2 and power prices, albeit that the preciseimpact and direction for prices depends on a largenumber of other factors such as the generation

mix, oil and gas prices, and demand. Thishighlights the EU’s continuing commitment tocutting greenhouse gas emissions, and to meetingtargets under the Kyoto Protocol.

Windfall profits will diminish as free allowancesgo downUnder Phase 1 of the ETS, free allowancescovered a very significant share of generators’actual and forecast CO2 emissions. Despite anexpected reduction of free allowances granted togenerators in Phase 2, we expect the windfallprofits generated in liberalized energy markets--such as the U.K., Germany, and the Nordicmarket--to continue, albeit to a lesser extent,reflecting a pricing strategy based on the marginalcost of generation (i.e. including emissions costs).The windfall benefit remains controversialbecause it applies not only to nonemittingfacilities but to all--including coal plants, whichemit the most GHGs. Many industrial end usershave voiced their discontent. They maintain thatwhile end users suffer from the higher cost ofelectricity due to the cost of CO2 emissions, theelectricity generators--those actually releasingmuch of the CO2--are gaining incremental profits.As a result, Standard & Poor’s expects that thelevel of free emission allowances granted to fossilfuel-fired generators may continue to go down infuture phases of the ETS (2012 and beyond).These generators will therefore either have to buya greater proportion of their carbon allowances inthe market or actually reduce CO2 emissions.They could cut their carbon output by switchinggeneration from coal-fired to less CO2-intensivegas-fired generation, improving the efficiency oftheir coal plants, or by using carbon capture andsequestration (CCS) storage technology.

Climate Change Policies PresentInvestment ChallengesIn addition to its focus on slowing climate change,the EU is also trying to increase competition inthe power sector and to reduce dependence onimported gas, two goals that it believes arecompatible. EU climate change and marketliberalization policies have to date favored gasand--to a much lesser extent--wind power in thegeneration mix at the expense of coal, as windand gas are cleaner than coal and it takes lesstime to build a gas plant than it does to build acoal plant, an important factor in liberalized


UTILITIES

markets. From a security-of-supply perspective,however, the resulting larger exposure to gasimports, particularly from Russia, raises a numberof concerns about the EU’s import dependency.For European utilities, these potentially conflictingpriorities present challenges in investmentplanning. This emphasizes the potentiallyimportant role that could be played bytechnologies to reduce the CO2 intensity of coaland by nuclear power in mitigating security-of-supply risk while meeting GHG reduction targets.

The European Council’s recent decision toadopt a variable 20%-30% GHG reduction targetby 2020 reflects the still significant uncertaintyabout the form and breadth that any successor

treaty to the Kyoto Protocol may take (assumingthat the successor treaty has sufficientinternational support, the EU is willing to committo a 30% reduction target, if all developednations agree to comparable targets). In addition,companies operating with GHG constraints underthe ETS do not know what the absolute level ofGHG caps will be beyond Phase 2, or what thelevel of free allowances at the installation orcompany level will be. Of course, if the EU wereto adopt a 30% rather than a 20% GHGreduction target, the emissions cap would need tobe tighter to support a higher emissions price andthe higher target. Electricity generators operatingin liberalized markets such as the U.K., Germany,

(Mil. tons) Cap 2005 Verified Cap allowed Additional emissions2005-2007 2005-2007 emissions 2008-2012 in 2008-2012*

Austria 33.0 33.4 30.7 0.4

Belgium 62.1 55.6¶ 58.5 5.0

Czech Republic 97.6 82.5 86.8 N/A

Estonia 19.0 12.6 12.7 0.3

France 156.5 131.3 132.8 5.1

Hungary 31.3 26.0 26.9 1.4

Germany 499.0 474.0 453.1 11.0

Greece 74.4 71.3 69.1 N/A

Ireland 22.3 22.4 21.2 N/A

Latvia 4.6 2.9 3.3 N/A

Lithuania 12.3 6.6 8.8 0.1

Luxembourg 3.4 2.6 2.7 N/A

Malta 2.9 2.0 2.1 N/A

The Netherlands 95.3 80.4 85.8 4.0

Poland 239.1 203.1 208.5 6.3

Slovakia 30.5 25.2 30.9 1.7

Slovenia 8.8 8.7 8.3 N/A

Spain 174.4 182.9 152.3 6.7§

Sweden 22.9 19.3 22.8 2.0

U.K. 245.3 242.4** 246.2 9.5

Total 1,834.7 1,685.2** 1,663.5 53.4

*The figures indicated in this column comprise emissions from installations that come under the coverage of the scheme in 2008-2012 due to an extendedscope applied by the member state and do not include new installations entering the scheme in sectors already covered in the first trading period.¶Including installations that Belgium opted to exclude temporarily from the scheme in 2005. §Additional installations and emissions of more than 6 milliontons 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 coveredin 2008-2012 and are estimated to amount to about 30 million tons. CO2--Carbon dioxide. N/A--Not applicable. Source: DG Environment (reference:IP/07/613, May 4, 2007).

Member State Annual CO2 Allowances Under The EU Emissions Trading Scheme


UTILITIES

Evolving political climate suggests long-termpotential for increased nuclear generation The long-term outlook for significant nuclearconstruction is better today than it has been formany years. If the industry can overcome itsunique problems of safety, decommissioning, andwaste storage, and if political and socialacceptance increases, a new generation of powerplants could be built in the U.K. New build iscurrently being undertaken in France and Finland,with potential for new plants in the Baltic regionand across a number of the Eastern Europeanmember states. The German nuclear consensus,which caps the lifetime of nuclear plants at 32years and requires them to be phased out, couldpossibly be revisited, although the policies ofGermany’s main political parties differ sharply onthe question of nuclear power.

Nuclear has a competitive advantage in termsof CO2 emissions and security-of-supply riskmitigation, and longer term visibility on the priceof CO2 and the level of allowances that will beprovided to fossil-fuel generators, for example,could have a strong impact on the profitability ofnew nuclear generation.

Clean Coal And CCS Could Allow Coal-Heavy Economies To Meet Reduction TargetsGHG reduction targets could present medium-term credit risk to companies that are heavilyexposed to coal-fired generation such as DraxPower Ltd. (BBB-/Stable/--). Larger, morediversified companies like CEZ a.s. (A-/Stable/--),Vattenfall, and RWE that also generate powerusing coal face increasing risk that the relativeeconomics and social acceptance of coal-firedgeneration may deteriorate.

Although liberalization and climate changepolicies favor gas-fired over coal-fired generation,the latter reduces fuel supply risk and dependenceon fuel imports from Russia, the Middle East, andAfrica. Recognizing this and the economic andsocial dependence of several EU countries on coal,the European Council has urged member statesand the Commission to work towardstrengthening R&D and developing the necessarytechnical, economic, and regulatory frameworksto deploy environmentally safe CCS through newfossil-fuelled power plants--if possible, by 2020.According to the EU, “coal can continue to make

its valuable contribution to the security of energysupply and the economy of both the EU and theworld as a whole only with technologies allowingfor drastic reduction of the carbon footprint of its combustion.”

Policymakers and certain generators aretherefore researching ways of making coal moreefficient and environmentally friendly, primarilythrough “clean coal” technologies and CCS. RWEhas made it clear that it will continue to buildcoal plants, but with the help of clean-coaltechnologies it will achieve CO2 reductionrequirements. Vattenfall has similar plans.

Cleaner coal is possible, but there are drawbacksThe two leading clean-coal technologies areintegrated gasification combined-cycle technology(IGCT) and supercritical technology. IGCT turnscoal into gas (usually hydrogen and other by-products) and then burns this gas in a traditionalgas-fired combined-cycle unit (with somemodification to accommodate the burning ofhydrogen). Supercritical technology works on theprinciple that the fuel efficiency of a traditionalsteam coal plant can be raised if it operates at ahigher temperature and pressure. Both approacheshave drawbacks, however. Supercriticaltechnology, although no more expensive thantraditional techniques, does not reduce CO2emissions to anywhere near the levels of otherfuels. And IGCT’s effectiveness comes at a cost,threatening the relative economics of coalproduction and reducing the incentive forcompanies to invest in new coal plants.

CCS could enhance competitive position of coal-fired generation, despite costs CCS involves capturing carbon and piping itunderground before it reaches the atmosphere.The technology could significantly enhance thecompetitive position of coal-fired generation byalleviating its environmental impact, which wouldenable coal to maintain a role in the EUgeneration mix and would also mitigate security-of-supply risk. CCS has a number ofdisadvantages, however: Its use would increasecosts, and its technical effectiveness andscalability is still unproven. Nevertheless,decarbonizing economies and industrial andgeneration processes clearly will not happenwithout cost and investment, and the EU and a


number of member states have announced theirintention to champion CCS technicaldevelopment. The U.K. government, for example,announced in March 2007 a competition todevelop the U.K.’s first full-scale CCSdemonstration (the details are likely to beannounced in the U.K.’s Energy Policy WhitePaper, which could be published as early as May2007). And the EU has said it would like to see12 large-scale CCS projects operational by 2015CCS. It also aspires to seeing CCS capture 4.5%of CO2 emissions from fossil fuel power plants by2020, rising to 30% by 2030.

The future of coal-fired generation will besignificantly affected by the extent to whichmember states will subsidize or otherwiseincentivize CCS. In the absence of such support,CCS development could be hindered and couldrender coal uneconomical and further weaken itscompetitive position in the generation mix. Giventhe importance of coal-fired generation to theEU’s goal of easing supply risk, however, weexpect policymakers to continue examining waysto speed the development of clean-coal and CCS technologies.

Note In 2004, public electricity and heat productionaccounted for 24% of EU-15 GHG emissions.The other main sources were road transportation(19%), manufacturing industries and construction(13%), industrial processes (8%), agriculture(9%), residential emissions (10%), waste (3%),and oil refining (3%).Additional writing by Anna Crowley. ■

UTILITIES

ELECTRICITE DE FRANCE S.A.

UTILITIES


RationaleThe ratings on French electricity incumbentElectricité de France S.A. (EDF) reflect its stand-alone creditworthiness--which would ensure an‘A+’ rating--and a one-notch uplift for statesupport, given the group’s primary focus onnuclear power generation and the entailedsignificant operational risks and decommissioning liabilities.

EDF’s stand-alone credit quality reflects thesignificant contribution to earnings, especially inFrance, of regulated businesses; its leadingposition by far in the only moderately competitiveFrench generation and supply market,underpinned by its efficient nuclear generationfleet; the refocusing of its international operationson Western Europe; and its superior freeoperating cash flow generation. These strengthsare offset to a degree by EDF’s financial profilewhich, although improving, remains moderategiven sizable unfunded postretirement and nuclear liabilities.

EDF’s French operations (64% of 2006EBITDA) are split between regulated transmissionand distribution operations (40% of FrenchEBITDA), and competitive generation and supplyoperations (60%). EDF’s leading position in thelatter is underpinned by its efficient nuclearplants, which accounted for 88% of its Frenchelectricity production in 2006. EDF’s Frenchsupply operations benefit only in part from higherwholesale power prices, however, as about two-thirds of sales are made at much lower, regulatedsupply prices. These have been rising recently,albeit slowly.

The group has refocused its internationaloperations on the U.K. (9% of 2006 EBITDA),Germany (7%), and Italy (6.6%). EDF’s financialprofile has improved with funds from operations(FFO) coverage of adjusted net debt of 22.5% in2006, thanks to the group’s superior free cash

flow generation, which, excluding taxexceptionals of €0.5 billion, was €6.2 billion in2006. To a large extent this reflects the cash flowprofile of EDF’s nuclear plants, which, whilerunning, are highly cash generative given lowvariable costs and limited capital expenditure for maintenance.

EDF’s financial profile remains moderate,though, given substantial net unfunded nuclearand postretirement benefit obligations of €19billion and €10.6 billion, respectively, in 2006.EDF will be increasing its dedicated assetscovering nuclear liabilities by €12.1 billionbetween 2006 and 2010, however.

Short-term credit factorsThe ‘A-1+’ short-term rating is supported byEDF’s strong liquidity and recurring free cashflow generation. EDF’s available cash andliquidity of €13.4 billion at year-end 2006--whichincludes the proceeds of the €6.35 billion capitalincrease at the end of 2005--together with a €6billion undrawn long-term syndicated bankfacility maturing in 2012 at the Electricité deFrance level, more than adequately cover thegroup’s €8.7 billion of long- and short-termfinancial debt maturing in 2007.

OutlookThe stable outlook reflects Standard & Poor’sRatings Services’ expectation that EDF willmaintain a financial profile in line with theratings, in particular FFO coverage of fullyadjusted net debt in excess of 20% (22.5% in2006). EDF has the flexibility within the currentratings to carry out its significant €26 billioninvestment program for 2006-2008. The ratingsalso factor in EDF’s retention of significantregulated operations and the continued support ofthe Republic of France (AAA/Stable/A-1+). ■

Publication Date:

Aug. 29, 2007

Issuer Credit Rating:AA-/Stable/A-1+

Primary Credit Analyst:Hugues De La Presle, Paris, (33) 1-4420-6666

Secondary Credit Analyst: Beatrice de Taisne, London, (44) 20-7176-3938

ENDESA S.A.

UTILITIES


RationaleThe ratings on Spanish utility Endesa S.A. wereplaced on CreditWatch with negative implicationson Sept. 6, 2005, at the start of what has sincebeen a very long and protracted bidding war forthis company.

On April 11, 2007, Italian utility Enel SpA(A/Watch Neg/A-1) and Spanish constructioncompany Acciona S.A. (not rated) announced a €41.3 per share conditional all-cash jointtakeover bid for the remaining 54% of Endesa’sthat they do not own. This represents an offervalue of nearly €25 billion. Enel has a 25% stakein Endesa, and Acciona owns 21%. The offer hasreceived all regulatory approvals and is nowsubject only to shareholder approval.

The CreditWatch status reflects the risks anduncertainties that surround this new bid, as wellas those presented by Endesa’s potential futurestrategy and financial structure after theprospective change of ownership. Furthermore,Endesa’s business profile will change if the offer issuccessful, owing to the asset split agreed betweenthe new bidders and German utility, E.ON AG(A/Stable/A-1). The agreement stipulates thatE.ON will receive a portfolio of Endesa assets inSpain, Turkey, and Poland, as well as Endesa’sshare of Endesa France and Endesa Italia, andassets in Spain owned by Enel (through Enel-Viesgo), for a total estimated value of €10 billion.

The terms and conditions of the bid reflect Eneland Acciona’s March 26, 2007, agreement. Theoffer is conditional upon a minimum acceptanceof 50% of the share capital and the amendmentof some of Endesa’s bylaws, including the removalvoting-right restrictions. Acciona will purchaseabout 4% of Endesa’s capital, and Enel willpurchase the rest of the tendered shares; bothcompanies, however, will have equalrepresentation on Endesa’s board.

One of the world’s largest electricity utilities,Endesa has total installed capacity of 47,385 MW

and 22.7 million customers. It has a market shareof about 40% of Spain’s electricity production,distribution, and supply. This strong domesticposition is one of the main rating supports.Operations in Spain and Portugal provided about55% of EBITDA in 2006 and 52% in the firsthalf of 2007.

Short-term credit factorsThe short-term rating is ‘A-1’, reflecting Endesa’sacceptable liquidity. At June 30, 2007, thecompany (excluding subsidiary Enersis S.A.{BBB/Stable/--}) had €6.2 billion in undrawn,committed facilities, and about €0.3 billion incash and equivalents, which together cover thefinal dividend paid against 2006 earnings on July2, 2007, and debt maturing over the next 23 months.

At the same date, Enersis had €0.5 billion inundrawn, committed facilities, and about €0.5billion in cash, together covering debt maturing atEnersis over the next 19 months. Endesa’s debtmaturity schedule is manageable, and the averagelife of the debt is 5.3 years.

According to Endesa, there are no cross-defaultclauses for the debt at Enersis or any of itssubsidiaries, and these entities are financed on anonrecourse basis.

Endesa generated funds from operations ofabout €4.6 billion in 2006. This strongperformance should continue, mitigating thefinancial-flexibility constraints arising from theutility’s large capital-expenditure plan andgenerous dividend policy. Endesa is committed topaying out 100% of capital gains on assetdisposals and increasing ordinary dividends by atleast 12% annually. This will result in thepayment of €9.9 billion in dividends over 2005-2009, of which €4.4 billion has already beenpaid. A change in financial, investment, anddividend policies may result, however, from theprospective change in control. ■

Publication Date:

Aug. 10, 2007

Issuer Credit Rating:A/Watch Neg/A-1

Primary Credit Analyst: Ana Nogales, Madrid, (34) 91-788-7206

Secondary Credit Analyst: Peter Kernan, London, (44) 20-7176-3618


RationaleThe ratings on Enel SpA remain on CreditWatchwith negative implications, where they wereplaced on April 3, 2007, following the company’s€40 billion joint debt-financed takeover bid withSpanish construction firm Acciona S.A. for 100%of Spanish utility Endesa S.A. (A/Watch Neg/A-1).

The continued CreditWatch listing reflectsStandard & Poor’s Ratings Services’ expectationsthat Enel’s financial profile will further deteriorateas a result of the tender offer for Endesa. Theoffer was completed on Oct. 1, 2007, and Enelnow owns 67% of Endesa. In connection withthis acquisition, Enel and Acciona will sell certainEnel and Endesa assets in Italy, France, Poland,Turkey, and Spain to German utility E.ON AG(A/Stable/A-1) in the first half of 2008 for anexpected €13 billion-€14 billion.

We expect to resolve the CreditWatch statusonce details about Enel’s business strategy andcapital structure are available.

The current ratings reflect Enel’s significantposition in the Italian power market, which issustained by its vertically integrated operations.The acquisition of Endesa should enhance Enel’sbusiness profile, through increased size anddiversification. In addition, operating synergiescould be material. Enel’s ability to reap thepotential benefits, however, will depend on itsdegree of control of Endesa and the functioningof its partnership with Acciona. Although thetransaction will enhance Enel’s business profile, itwill lead to a material deterioration in thecompany’s financial position, notwithstanding thebenefit of the asset sales to E.ON. Enel’s debt-financed investment in Endesa totals about €28 billion (equity value). This compares withnet reported debt of €24.8 billion at Sept. 30,2007, which already included the debt financingof a 25% Endesa stake.

Enel’s acquisition earlier this year of about €1.8 billion in Russian assets and its desire tobecome an integrated energy player in the Russianmarket will also weigh negatively on thecompany’s credit quality, due to country andindustry risks, as well as to the financial impact.

The company’s public announcement that it hasnow almost completed its M&A activity and thatit will focus on integrating all of its internationalassets somewhat reduces acquisition-related risks.

Short-term credit factors Enel’s short-term rating is ‘A-1’. At Sept. 30,2007, the company had committed credit lines of€5 billion, of which €2 billion had been drawn,and uncommitted credit lines of €2.6 billion, ofwhich €0.9 billion had been drawn. The financedocumentation for these facilities does not includematerial covenants. In addition, Enel had a €35billion committed credit line to fully finance theEndesa acquisition, which has now been reducedto €23 billion after the June and September bondissues and the results of the Endesa tender offer.This credit line is split into three tranches withdifferent maturities: 1) one year, subject to a term-out option for a further 18 months, for a residualamount of €2.5 billion; 2) three years, for aresidual amount of €12.3 billion; and 3) fiveyears, for a residual amount of €8.2 billion.Consequently, short-term refinancing risk seemsmodest. Given Enel’s size and market position,and the successful placement of its $3.5 billionbond issued in the U.S., access to the capitalmarkets and the ability to issue debt of anappropriate tenor are not credit concerns, evenunder current market conditions. Enel’s ultimatedebt profile, in terms of maturity andcomposition, will depend upon the permanentfinancing that it arranges to replace theacquisition facility. ■

ENEL SPA

UTILITIES

Publication Date:

Nov. 12, 2007


Primary Credit Analyst: Ana Nogales, Madrid, (34) 91-788-7206

Secondary Credit Analyst: Peter Kernan, London,(44) 20-7176-3618


E.ON AG

RationaleThe ratings on Germany-based utility E.ON AGfactor in that the company will releverage itsbalance sheet through increased organicinvestment, a share buyback, and acquisitionexpenditure. Specifically, the ratings incorporatethe assumption that the company’s funds fromoperations (FFO) to net adjusted debt will remainabove 20% and at levels commensurate with an‘A’ rating (absent any greater-than-expectedincrease in business risk that could necessitate ahigher level of credit protection).

E.ON’s revised medium-term strategy includessignificant organic growth investments (a €60billion investment program has been budgetedthrough 2010), increased returns to shareholders(a €7 billion share buyback by the end of 2008),and more active management of the balance sheet.Further to E.ON’s decision to withdraw its €70billion bid for Endesa S.A. (A/Watch Neg/A-1) ofSpain, E.ON has an agreement with Enel SpA(A/Watch Neg/A-1) and Acciona to acquiregeneration assets from Enel and Endesa mainly inItaly, Spain, and France for an estimatedenterprise value of €10 billion, if Enel andAcciona gain control of Endesa. Largeacquisitions also remain possible but are expectedto be funded in line with the company’s minimumrating target of ‘A’ and its 3x economic net debt-to-EBITDA target ratio (barring any materialchange in its business risk). As at Dec. 31, 2006,E.ON calculated that its ratio of economic netdebt to EBITDA was 1.5x.

Standard & Poor’s Ratings Services regards thecompany’s business risk profile, pro forma for thenew higher investment program, as slightlyincreased compared with the Endesa acquisitionbid, owing to the lack of acquired verticalintegration (including distribution assets) andfocus on riskier growth markets.

E.ON expects its European generation capacityto increase by 50% to 69 gigawatts (GW) from46 GW by 2010, of which about 12 GW willcome from generation assets and projectsacquired under the agreement with Enel andAcciona. A materially increased earningscontribution from undiversified generation orfrom riskier growth markets could ultimatelyweaken E.ON’s business risk profile. That said,the company still clearly recognizes the benefit ofintegrated generation and supply operations andfairly matched position, especially in highly

competitive markets, as well as a proactivegeneration margin hedging policy (for 2007 and2008, 90% and more than 60%, respectively, ofE.ON’s economic generation has been hedged).

Short-term credit factorsThe short-term rating on E.ON is ‘A-1’, reflectingthe company’s significant cash flows, a securitiesportfolio totaling about €11 billion at Dec. 31,2006 (notionally available to meet future pensionand nuclear liabilities), and significant unusedfacilities--specifically, an undrawn €10 billionsyndicated multicurrency loan.

E.ON’s liquidity also benefits from the group’ssignificant operating cash flow. In 2006, underU.S. GAAP, cash provided by operating activitieswas almost €7.2 billion, which comfortablyfinanced E.ON’s 2006 capital expenditure of €4.1 billion, and made a significant contributionto the group’s €4.6 billion dividend paid in 2006.Although capital and investment expenditure willincrease significantly and free cash flows beforedividends might be negative and reach a lowpoint in 2008, a significant portion of firmlyplanned capital expenditures and increaseddividends should remain internally funded over2007-2009. Ongoing financial flexibility issupported by the largely discretionary nature ofthe planned investments as well as E.ON’s wideand discrete asset base, which could be reducedwithout affecting crucial core operations.

OutlookThe ratings factor in E.ON’s plans to significantlyreleverage its balance sheet. The stable outlookreflects the company’s continued strong financialflexibility. The ratings could conceivably improvein the case of a better-than-expected businessprofile, for example due to riskier investments notmaterializing (and barring other material changesin the company’s business environment).

A significantly better-than-expected financialprofile could also have a positive effect on theratings. The ratings could deteriorate, forexample, due to greater-than-expected businessrisk from German or EU-wide regulatoryinitiatives or significantly increased exposure tothe Russian Federation or Eastern Europe.Neither scenario is expected to have an impact onthe ratings in the near term, owing to E.ON’sclearly articulated strategy and its strong financialprofile for the ratings. ■

Publication Date:

Aug. 28, 2007

Issuer Credit Rating:A/Stable/A-1

Primary Credit Analyst:Peter Kernan, London,(44) 20-7176-3618

Secondary Credit Analysts:Ralf Etzelmueller,Frankfurt, (49) 69-33-999-123

Amrit Gescher,London,

(44) 20-7176-3733

UTILITIES


RationaleOn Sept. 3, 2007, Standard & Poor’s RatingsServices said that its ‘AA-/A-1+’ ratings on Frenchgas utility Gaz de France S.A. (GDF) remain onCreditWatch with negative implications followingthe announcement of the revised terms for themerger between GDF and Franco-Belgian multi-utility Suez S.A. (A-/Watch Pos/A-2). The ratingswere placed on CreditWatch on Feb. 27, 2006,following the initial merger announcement.

The continued negative CreditWatch reflectsthat, notwithstanding changes in the terms of themerger, it should have a dilutive impact on GDFfrom a credit standpoint--in terms of bothbusiness and financial risk--given Suez’s weakerbusiness mix and financial profile. This is despitethe fact that the merger would address GDF’sstrategic issues, especially those related to itsplans to expand further abroad and in electricity.

From a business risk perspective, although Suezis larger and more diversified than GDF, Standard& Poor’s views GDF’s business risk as lower,given the large share of earnings it derives fromregulated French businesses. From a financial riskperspective, although Suez’s financial profile hasimproved, its credit ratios remain significantlyweaker than GDF’s.

Under the revised terms, 21 GDF shares will beexchanged for 22 Suez shares, with no specialdividend being paid. Initially the terms of themerger were a one-for-one share exchange plus a€1 billion special dividend to be paid to Suezshareholders prior to completion. To mitigate thedifference in the share prices of Suez and GDF,65% of the share capital of Suez’s environmentarm (20% of first-half 2007 Suez EBIT) will be

spun off to Suez’s shareholders at the time of themerger, with the enlarged group retaining a 35%stake. The environment business had reported netdebt of €5.4 billion at the end of June 2007, out of Suez’s reported consolidated debt of €12.9 billion.

Although the lack of a special dividend and thespin-off of Suez Environment--given its significantdebt--are favorable from a financial standpointcompared with the initial terms, the enlargedgroup intends to offer substantial returns to itsshareholders. From a business perspective,although the European water operations (39% ofthe EBIT of Suez Environment in first-half 2007)rank amongst Suez’s strongest businesses, theywould have been small in the context of theenlarged group.

These revised terms are a significant stepforward but the merger still faces some hurdles,especially its approval by both groups’shareholders; the signing of the decree allowingthe privatization of GDF following the passing ofthe law in the French parliament; and theopposition of GDF’s unions.

To resolve the CreditWatch placement we willfocus on the enlarged group’s strategy andfinancial policy.

Short-term credit factorsThe ‘A-1+’ short-term rating is supported byGDF’s sound liquidity, with available cash at theend of June 2007 of about €3 billion and anundrawn €3 billion committed syndicated creditfacility, which more than cover short-term debtmaturing in the next 12 months of €1.1 billion.Beyond 2007, GDF has limited debt maturities. ■

GAZ DE FRANCE S.A.

UTILITIES

Publication Date:

Sept. 3, 2007

Issuer Credit Rating:AA-/Watch Neg/A-1+


Secondary Credit Analyst:Beatrice de Taisne, London, (44) 20-7176-3938


UTILITIES

RationaleThe ratings on Spanish utility Iberdrola S.A.remain on CreditWatch with negative implicationsfollowing the acquisition of Scottish Power PLC(A-/Watch Neg/A-2) on April 23, 2007, and thecompany’s announcement on June 25, 2007, of itsbid to acquire 100% of U.S. utility Energy EastCorp. (BBB+/Negative/A-2).

For a summary of Iberdrola’s CreditWatchhistory, see the section “CreditWatch History”toward the end of this article.

Iberdrola will pay €3.4 billion in cash andassume Energy East’s debt of €3 billion. Thetransaction, subject to approval by Energy East’sshareholders and to receipt of all the necessaryauthorizations, is expected to close in the secondhalf of 2008. Notwithstanding this, Iberdrola hasalready raised close to €3.4 billion of new equityto fund this transaction.

Energy East is a holding company that owns sixregulated utilities (mainly transmission anddistribution) and several smaller, nonregulatedcompanies in upstate New York, Connecticut,Maine, and Massachusetts.

The ratings will remain on CreditWatchpending Standard & Poor’s meeting withIberdrola in the second half of 2007 to discuss thegroup’s revised business and financial strategy andanalyze its financial forecasts and plannedfinancial structure. We will also focus on thegroup’s future risk tolerance and acquisitionstrategy. Standard & Poor’s understands thatIberdrola aims to maintain an ‘A’ category rating.

Based on publicly available information, weexpect any lowering of our long-term rating onIberdrola upon resolution of the CreditWatchlisting to be limited to one-to-two notches. Thispreliminary assessment does not, however, includethe potential fiscal benefits from the amortizationof the goodwill from the acquisition of ScottishPower PLC or from synergies from ScottishPower’s integration within Iberdrola.

Iberdrola’s strong position as one of Spain’s twolargest vertically integrated electricity groupsunderpins the ratings. The recently acquiredbusiness will increase the group’s earningsdiversity, both geographic and operational, butwill result in a weaker capital structure and willpresent integration challenges. At March 31,2007, the group’s debt and EBITDA pro-formafigures (including the Scottish Power acquisition)were €29.8 billion and €5.8 billion, respectively.

Short-term credit factorsIberdrola’s short-term rating is ‘A-1’, underpinnedby an acceptable liquidity position prior to theacquisition of Scottish Power. At end-March2007, available cash, short-term financialinvestments of €1.15 billion, and committedundrawn credit facilities of €2.2 billion, morethan fully covered the €1.1 billion in debtmaturing in 2007. In addition, the groupannounced on May 28, 2007, that it intends tocarry out a partial IPO of the combined group’srenewable business, which could generate €3.3 billion-€4.5 billion.

CreditWatch History The ratings on Iberdrola were placed onCreditWatch with negative implications on Sept.6, 2005, following Spanish utility Gas NaturalSDG, S.A.’s (A+/Negative/A-1) €22.55 billion bidfor a 100% stake in Endesa S.A. (A/WatchNeg/A-1) and its agreement to a subsequent saleof an estimated €7 billion-€9 billion in assets toIberdrola. On Dec. 1, 2006, we lowered our long-term rating on Iberdrola to ‘A’ from ‘A+’, owingto the group’s offer for Scottish Power made onNov. 28, 2006. The ratings on Iberdrola haveremained on CreditWatch with negativeimplications since then, despite the withdrawal ofGas Natural’s bid on Feb. 1, 2007, owing to theexpected negative financial impact of theacquisition of Scottish Power. ■

IBERDROLA S.A.

Publication Date:

July 4, 2007


Primary Credit Analyst: Ana Nogales, Madrid,(34) 91-788-7206

Secondary Credit Analyst:Peter Kernan, London, (44) 20-7176-3618


RationaleThe ratings on Germany-based utility RWE AGreflect the group’s strong competitive position inthe German electricity market, which provides themajority of group earnings and has deliveredsustained strong operating performance. Theratings also reflect the group’s strong financialprofile. These strengths are partially offset by theweakening of RWE’s business profile followingthe sale of its regulated water operations and itsreliance on competitively exposed generation forfuture growth.

Competition in the German retail marketremains moderate. Nevertheless, the introductionof a network regulator and tariff cuts will likelyincrease competitive pressures. Meanwhile, RWE’ssubstantially lower level of freely granted carbondioxide (CO2) allowances for phase 2 of the EUEmissions Trading Scheme (2008-2012) will likelyreduce generation margins. (RWE estimates thatslightly more than 50% of its German CO2emissions will be covered by free allowances.)RWE will, however, benefit from changes in theGerman tax regime, which will result in theaverage tax rate on German profits dropping to31% from about 39%, from 2008.

RWE’s balance sheet has further strengthenedfollowing the sale of RWE Thames Water for anenterprise value of £8.0 billion (sale price of £4.8billion plus pro forma net debt of £3.2 billion) inDecember 2006. At June 30, 2007, net debt(including pension provisions, and under RWE’sdefinition) was €6.8 billion. RWE plans tocomplete the sale of its U.S. water businessthrough an IPO by the end of 2007, subject tomarket conditions, which will further deleveragethe group. RWE has a general net debt cap ofbetween €22 billion and €24 billion and hassubstantial headroom relative to this cap toincrease leverage. RWE has material nuclear assetretirement obligations, of which Standard &Poor’s Ratings Services treats about €7 billion as debt.

The group’s financial performance has beenstrong over the past few years, with funds fromoperations (FFO) increasing to more than €7billion for full-year 2006, on the back of strongpower prices. The medium-term outlook forpower prices continues to be favorable on theback of tight capacity margins and tightness infuel markets--given strong global demand forcommodities--as well as a tighter market for CO2.

RWE’s target for 2007 is that revenue will riseslightly above the 2006 level of €44.2 billion andthat EBITDA will rise by between 5% and 10%above the 2006 level of €7.17 billion.

There is an ongoing debate within the EU aboutlevels of competition in power markets, and adraft third liberalization directive is expected laterin 2007. Among other areas, the debate hasfocused on ownership unbundling of transmissionbusinesses to increase competition. Such ameasure could adversely affect RWE’s Germanbusiness, but Standard & Poor’s currentlyconsiders that it is unlikely that this change willbe required.

Short-term credit factors The ‘A-1’ short-term rating is underpinned bylarge and diversified cash flows (cash flows fromoperating activities were in excess of €2.5 billionfor the six months to June 30, 2007), RWE’scurrent low level of net debt, and a benignmaturity profile. The rating is also supported bysubstantial alternative sources of liquidity,including more than €12 billion of liquidsecurities held to offset on-balance-sheet nuclearliabilities. At Dec. 31, 2006, €5.5 billion ofRWE’s €20.0 billion debt issuance program wasavailable. RWE faces a moderate maturity peak ofabout €3.7 billion in 2007. In addition, thecompany had unused funds of €3.5 billionequivalent under its $5.0 billion CP program atDec. 31, 2006.

Outlook RWE’s financial profile is strong for the ratings.The negative outlook, however, reflects somenear-term uncertainty about the direction ofRWE’s strategy, financial and acquisitionspolicies--in part due to planned changes in seniormanagement--and the manner in which RWEcould releverage its balance sheet.

The deterioration of RWE’s business profile as aresult of the water disposals could negativelyaffect the ratings if the disposals are followed byrapid and substantial investments in riskieroperations. To maintain the ratings, RWE needsto restrict itself to moderate-scale or low-riskacquisitions, and maintain conservative financialpolicies. The outlook could be revised to stable if RWE maintains its current strong financial profile. ■

RWE AG

UTILITIES

Publication Date:

Aug. 17, 2007

Issuer Credit Rating:A+/Negative/A-1

Primary Credit Analyst:Peter Kernan, London, (44) 20-7176-3618

Secondary Credit Analysts:Amrit Gescher, London, (44) 20-7176-3733

Ralf Etzelmueller, Frankfurt, (49) 69-33-999-123


SCOTTISH AND SOUTHERN ENERGY PLC

RationaleThe ratings on U.K.-based energy utility Scottishand Southern Energy PLC (SSE) and itssubsidiaries are supported by strong, predictablecash flows from the group’s regulated monopolyelectricity and gas network businesses, which willlikely contribute 40%-45% of operating profitsover the medium term. The group’s strongfinancial profile, low-cost generation portfolio,and strong cost-cutting record also support the ratings.

These strengths are offset by the exposure ofSSE’s operating profits to movements inwholesale-power, coal, and gas prices as well asthe risk of customer losses in the highlycompetitive electricity and gas retail markets. Anincrease in the proportion of profits derived fromthe group’s unregulated businesses, which is likely,could increase business risk.

SSE is the third-largest electricity and gassupplier in the U.K. in terms of customernumbers. In June 2007, its customer base hadincreased to about 5 million electricity and 2.9million gas customers, despite a period ofsignificant increases in electricity and gas supplyprices. The company remains the cheapestsupplier of energy and was the first to reduceprices on March 1, 2007, lowering averageannual electricity and gas bills by 5% and 12%,respectively. The group has a relatively diversefuel portfolio compared with other U.K. power-station operators, which provides goodoperational flexibility and risk mitigation involatile markets.

SSE’s long generating and contractual positionin relation to its residential supply volumesexposes its cash flows to greater long-term pricerisk than some of its peers (although this positionis beneficial in a high wholesale-priceenvironment). Accordingly, cash flows at SSE arevulnerable to a downward shift in long-term gasand power prices, although any such trend shouldlargely be offset by higher supply margins. Inaddition, the company’s diverse fuel portfolioallows for optimization of fuel sources.

Standard & Poor’s Ratings Servicesproportionally consolidates the accounts of gasdistribution networks Southern Gas NetworksPLC (BBB/Positive/--) and Scotland Gas NetworksPLC (BBB/Positive/--)--including £1.1 billion ofdebt at March 31, 2007--into SSE’s financialstatements. This reflects our view that the twoentities (together known as Scotia) represent a

core investment for the group. Excluding Scotia,SSE’s financial profile remains solid. AdjustedEBITDA grew by more than 21% to £1.42 billionin the year ended March 31, 2007, from £839million one year earlier. Standard & Poor’sadjusted gross consolidated debt figure for SSE,excluding Scotia, was £2.66 billion at March 31,2007. This includes approximately £400 millionin adjustments for operating leases, postretirementdebt obligations, and power purchase agreements.

Short-term credit factorsThe short-term rating is ‘A-1’. SSE hassatisfactory liquidity, with a £650 million, five-year committed revolving credit facility due in2009 to cover maturing obligations (principallyCP). SSE’s debt is generally long term, with only£40 million due to mature before March 2008.The group has good access to CP markets under a €1.5 billion program, which it has used only lightly.

SSE will likely be required to raise debt andrefinance maturing bonds to fund capitalexpenditures in 2008. The group has good accessto capital markets, although it is a relativelyinfrequent issuer. Some financial flexibility isavailable from its dividends. SSE’s financialflexibility has improved, as its additional debtrequirement should be reduced in view ofplanning issues that are expected to delay theBeauly-Denny transmission line (which will havea knock-on effect on investment in majorrenewables projects in Scotland).

OutlookThe stable outlook reflects the likelihood that SSEwill maintain cash flow protection measures inline with our expectations. Consolidated FFO tointerest, excluding 50% contributions from Scotiathat Standard & Poor’s rates on a consolidatedbasis, will likely remain close to current levels ofabout 9x, with FFO to debt at about 42%.Acquisition activity could, however, result inhigher-than-expected debt levels, which could putpressure on the ratings. Furthermore, lower-than-expected gas or electricity prices, or any large-scale customer loss, could threaten cash flowratios, which could also weigh on the ratings.Retaining customers and energy-supply marginswill be challenging as wholesale prices fall backfrom the peaks of 2005 and 2006. Ratings upsidepotential is very limited over the short term. ■

UTILITIES

Publication Date:

Aug. 30, 2007

Issuer Credit Rating:A+/Stable/A-1

Primary Credit Analyst: Paul Lund, London, (44) 20-7176-3715

Secondary Credit Analyst:Mark J Davidson,London,(44) 20-7176-6306


RationaleOn Sept. 3, 2007, Standard & Poor’s RatingsServices said that its ‘A-/A-2’ ratings on Franco-Belgian multi-utility Suez S.A. remain onCreditWatch with positive implications, followingthe announcement of the revised terms for themerger between Suez and French gas utility Gazde France S.A. (GDF; AA-/Watch Neg/A-1+). Theratings were placed on CreditWatch on Feb. 27,2006, following the initial merger announcement.

The continued positive CreditWatch reflectsthat, notwithstanding changes in the terms of themerger, it should have a beneficial impact on Suezfrom a credit standpoint--in terms of bothbusiness and financial risk. From a business riskperspective this reflects that, although Suez is thelarger and more diversified company, Standard &Poor’s views GDF’s business risk as lower, giventhe large share of earnings it derives fromregulated French businesses. Likewise, from afinancial risk perspective, although Suez’sfinancial profile has improved significantly, GDFstill has much stronger credit ratios.

Under the revised terms, 21 GDF shares will beexchanged for 22 Suez shares, with no specialdividend being paid. Initially the terms of themerger were a one-for-one share exchange plus a€1 billion special dividend to be paid to Suezshareholders prior to completion. To mitigate thedifference in the share prices of Suez and GDF,65% of the share capital of Suez’s environmentarm (20% of first-half 2007 Suez EBIT) will bespun off to Suez shareholders at the time of themerger, with the enlarged group retaining a 35%stake. The environment business had reported netdebt of €5.4 billion at the end of June 2007, out

of Suez’s reported consolidated debt of €12.9 billion.

Although the lack of a special dividend and thespin-off of Suez Environment--given its significantdebt--are favorable from a financial standpointcompared with the initial terms, the enlargedgroup intends to offer substantial returns to itsshareholders. From a business perspective,although the European water operations (39% ofthe EBIT of Suez Environment in first-half 2007)rank amongst Suez’s strongest businesses, theywould have been small in the context of theenlarged group.

These revised terms are a significant stepforward but the merger still faces some hurdles,especially its approval by both groups’shareholders; the signing of the decree allowingthe privatization of GDF following the passing ofthe law in the French parliament; and theopposition of GDF’s unions.

To resolve the CreditWatch placement, we willfocus on the enlarged group’s strategy andfinancial policy.

Short-term credit factorsSuez’s European utility activities’ recurring cashflow generation and strong liquidity underpin the‘A-2’ short-term rating. Debt maturities in thesecond half of 2007 amount to €5.1 billion(including €2.3 billion of CP) and represent €3.3billion and €3.5 billion, respectively, in 2008 and2009. These are covered by about €8 billion ofavailable cash, excluding €1 billion of overdraftsin the next 12 months, while the group has €6.7billion of undrawn bank lines, excluding the €2.3billion of CP drawings. ■

SUEZ S.A.

UTILITIES

Publication Date:

Sept. 3, 2007

Issuer Credit Rating:A-/Watch Pos/A-2


Secondary Credit Analyst:Beatrice de Taisne, London, (44) 20-7176-3938


VATTENFALL AB

RationaleThe ratings on Sweden-based utility Vattenfall ABreflect its strong, vertically integrated position inthe north European electricity market, competitivegeneration portfolio, significant monopoly utilityoperations, and strong cash flow generation.

Negative rating factors include Vattenfall’sexposure to competition and price volatility inpower generation, political risks related to nuclearand coal generation, and increasing regulatorypressure on monopoly network operations.

Standard & Poor’s Ratings Services currentlyfactors no direct support from Vattenfall’s 100%owner, the Kingdom of Sweden, into the ratings.Political and taxation pressures on the companyhave increased, although the Swedish government appears to have no plans forrestructuring or major strategy changes. Inaddition, there is no plan to privatize Vattenfall in the foreseeable future.

Vattenfall’s capital expenditure is likely toincrease over the medium term. By 2011, thecompany plans to invest about Swedish krona(SEK) 134 billion, mainly in new powergeneration capacity, reinforcement of its electricitynetwork, and reinvestments.

Following the integration of its acquiredGerman operations, and the acquisition ofSEK12.6 billion (on a net basis) of Danish powergeneration assets in 2006, we expect Vattenfall tocontinue its growth strategy and to be acquisitive--both in its current markets and in neighboringEuropean countries. The number of potentialacquisition targets will likely be limited and anyacquisitions will be highly contested, however.

Vattenfall’s financial performance remainsstrong for the ratings, with funds from operationsto adjusted debt of about 39% in 2006 (treatingSEK8.9 billion in hybrid capital notes as 50%debt and 50% equity). Standard & Poor’s expectsVattenfall to exploit the financial headroom in thecurrent ratings through debt-financed acquisitionsor capital expenditures. In the absence of majoracquisitions or large scale capital expenditures,and in view of strong wholesale power pricedevelopments, funds from operations to adjusteddebt should remain at above 30% over themedium term.

Short-term credit factorsVattenfall’s short-term rating is ‘A-2’. Thecompany is expected to have adequate internalliquidity over the short term, reflecting strongoperating cash flow protected by hedgingarrangements, and significant access to alternativesources of liquidity. Although much of Vattenfall’soperations are in highly competitive and volatilemarkets, movements in sales prices and volumesare not expected to have a material negativeimpact on the company’s liquidity and financialperformance over the short term.

The company’s adequate liquidity position issupported by the following factors:

• Cash and short-term investments at March 31, 2007 of about SEK27.9 billion, compared with SEK15.9 billion in short-term debt.

• Strong free operating cash flow (about SEK23.4 billion for the twelve months ended March 31, 2007), reflecting solid profitability and manageable capital expenditure needs in the utility operations.

• Access to unused committed credit facilities of SEK9.7 billion as of March 31, 2007. In February 2006, the company refinanced a €600 million revolving credit facility and at the same increased the amount to €1 billion. The new revolver matures in 2013, and the company has good access to public debt markets.

• The absence of rating triggers or onerous covenants in Vattenfall’s financing agreements.

• Free operating cash flow is expected to remain at SEK5 billion-15 billion a year, based on sustained operating profitability.

• Company policy is to maintain the equivalent of 10% of group turnover in cash or committed credit lines, or the equivalent of the next 90 days’ debt maturities, whichever is greater.

OutlookThe stable outlook reflects the increasingregulatory and political pressure in Vattenfall’smain markets, which tempers the prospect ofcontinued improved credit quality from its current

UTILITIES

Publication Date:

June 11, 2007

Issuer Credit Rating:A-/Stable/A-2

Primary Credit Analyst: Mark Schindele, Stockholm,(46) 8-440-5918


strong level. Such pressure has resulted in increasing shareholder demands, stricterregulation, and an increased focus onenvironmental and energy policy objectives forthe company. Further adverse political or regulatory actions cannot be ruled out.

The stable outlook also reflects our expectationthat Vattenfall will continue its growth strategy,remain acquisitive, and increase capitalexpenditures over the medium term. This couldweaken the financial profile from its current,strong, level, although we do not expect thecompany to jeopardize its objective ofmaintaining a rating in the ‘A’ category. In thecurrent environment, with increased political andregulatory uncertainty, upside ratings potential is limited. ■

UTILITIES

Standard & Poor’s rates a wide range of transportation infrastructure entities in Europe, includingairports, rail companies, toll road concessions, and ports. Continuing the trend of recent years,2007 has been characterized by further M&A and privatization activity, with sponsors seeking to

significantly increase debt leverage on the back of solid business risk profiles to fund the acquisitionprice or provide for shareholder returns. As a result, we have seen a number of ratings on stableinvestment-grade entities withdrawn, only to be replaced by much more aggressive--and likely non-investment-grade--financial structures. Whether such structures are sustainable over the business cycle asit becomes more challenging remains to be seen.

In recent years, acquisition has been the easiest part of the equation given the plentiful supply ofcredit and this, for the vendor, has given meaty returns. For some new owners, the second stage--thesyndication of the acquisition debt into the secondary loan market or refinancing through the capitalmarket--is proving more elusive. For example, the approximate £6.7 billion of acquisition debtfollowing the acquisition of BAA PLC by Spanish infrastructure company Grupo Ferrovial S.A. remainsoutstanding 18 months after the launch of the acquisition despite the intention to undertake a capitalmarkets refinancing. While the delay reflects a combination of factors, including the regulatory processand the complexity of the structure being developed, it will be interesting to watch the eventualexecution and the price at which that occurs, given the changing climate of the credit markets.

Government support is and will remain a key credit factor, particularly for the rail industry. Yet,government budgetary constraints caused by weak economic conditions are putting increasing pressureon state support for some rail entities. State support is likely to remain integral to the operation of railinfrastructure and services in Europe, although more privatizations in the long term cannot be ruled outas countries look to alternative ownership and funding structures.

During 2007, Standard & Poor’s assigned its first ratings in the transportation sector in the MiddleEast to Dubai-based port operator DP World Ltd. As part of the company’s financing activity a ratingwas also assigned to an Islamic finance sukuk instrument. The importance of the relationship with thegovernment is fundamental to ratings within these jurisdictions, given the ownership structure and thesignificant social policy role that such companies often take.

In general, most rated companies in the sector continue to perform well on the back of economicgrowth and positive industry developments such as the ongoing growth of low-cost airlines in the case of airports. The sustainability of these positive market features in the long term may become achallenge to transportation infrastructure credits, although companies with prudent managementstrategies, solid operations, and manageable financial risk are likely to continue to meet the challengesthat the future brings.


TRANSPORTATION INFRASTRUCTURE


Jonathan MManleySenior Director and Co-Team LeaderProject Finance and Transportation Infrastructure

Lidia PPolakovicSenior Director and Co-Team LeaderProject Finance and Transportation Infrastructure

Publication Date:



In addition, on March 22, 2007, the EUapproved an aviation deal with the U.S. that willincrease deregulation of the transatlantic airlinemarket by opening up restricted routes. As aresult, we expect air traffic between Europe andthe U.S. to continue to increase over the next fiveyears, starting in 2008. For instance, the lifting ofprevious U.K./U.S. bilateral constraints on airservice provision between Heathrow and the U.S.is to be implemented at Heathrow in time forsummer 2008. The impact is currently beingassessed by BAA Ltd. (BBB+/Watch Neg/--) usinglatest airline thinking, but previous assessmentssuggested small net gains to London systemairports (2.3 million passengers in total over thecourse of the next five-year regulatory periods Q5and Q6). The impact may be higher for hubairports with more slot capacity.

Finally, 2007 traffic growth should be in line orslightly better than semi-annual growth for someairports. Traffic was very high this summer, whichwill benefit annual traffic levels: The 2006summer season was slightly affected by atemporary and limited passenger shortfallfollowing the 2006 terrorist alerts in London andsubsequent reinforcement of security measuresacross the EU.

First-half 2007 annual traffic growth washealthy, but slowed down for one-half of theairports compared with the same period of 2006.Given increasing capacity constraints in mostEuropean airports, more limited but steadygrowth could prove easier to manage from acapital planning point of view.

A detailed analysis suggests the following maintraffic drivers:

• International traffic continues to grow more rapidly than domestic traffic, which is likely to remain the case.

• Among international traffic, non-European (transfer) traffic has proved particularly dynamic.

• Low-cost carriers continue to grow more rapidly than others and represent a constantly climbing percentage of passengersat some airports; the airports’ traffic growth is, therefore, increasingly reliant on the success of these carriers.

Successful airport operators are those that arenot yet constrained by capacity and canaccommodate growing passenger volumes, whilesome hubs (Heathrow and Frankfurt, forexample) are increasingly constrained. As a resultof its spare capacity, Aeroports de Paris (ADP;AA-/Stable/--) recorded the highest traffic growthrates among major European airports in first-half2007, as in the three previous years, and is likelyto benefit again from strong traffic growth in2007; ADP has raised its full-year 2007 passengergrowth guidance to between 4% and 4.4%,versus 3.7%-4.2% previously. Traffic was actuallyup 5.2% in the first nine months of 2007.Continental regional and O&D airportscontinued to post the strongest growth and tooutperform hubs, mainly as a result of expansionin the low-cost segment. Only U.K.-based airportoperator Birmingham Airport Holdings Ltd.

Growth Growth Passengers Growth Growth Growth Growth2007f January 2007- 2006 January 2006- January 2006- January 2005- January 2004-

June 2007 December 2006 June 2006 December 2005 December 2004(%) (%) (mil.) (%) (%) (%) (%)

Aeroporti di Roma SpA 6.0-7.0 8.4 35.1 6.7 6.6 7.3 9.2

Aeroports de Paris 4.0-4.4 4.4 82.5 4.8 5.0 4.4 6.5

BAA Ltd. 1.5-2.0 0.5 147.6 2.3 3.1 3.0 6.9

Birmingham Airport Holdings Ltd. N.A. (0.5) 9.3 (2.5) 0.4 5.8 (2.3)

Brussels Airport Co. (The) 4.0-5.0 3.5 16.7 3.3 4.4 3.5 2.9

Copenhagen Airports A/S 4.0-6.0 2.3 20.9 4.5 6.3 5.0 7.5

Dublin Airport Authority PLC 7.5-8.0 8.4 27.8 15.0 16.2 12.4 6.6

FML Ltd. (East Line Group) 19.0 19.0 15.4 10.1 12.5 15.6 29.0

Manchester Airport Group PLC (The) 5.0 2.1 28.8 3.0 3.3 3.0 5.5

N.V. Luchthaven Schiphol 4.0 3.9 46.1 4.3 4.0 3.8 6.5

Unique (Flughafen Zurich AG) 7.0 8.1 19.2 7.6 6.0 3.7 1.3 f--Forecast. N.A.--Not available.

European Airports Traffic Growth


(BIA; A-/Stable/A-2) showed negative 0.5%growth in the first half of 2007: the semi-annualfigure suggests traffic is however decreasing lessrapidly than in full-year 2006 (2.5%). Second-half2007 and 2008 will be crucial to confirm whetherthis decline suggests a departure from BIA’s long-term growth trend.

Improved profitability and cash flow generationoverall but pressures mounting for some airportsWe expect most rated European airports’ EBITDAto improve in 2007, on the basis of more traffic,increases in airport charges, higher non-aeronautical revenues, and the implementation ofcost-cutting measures. Reported interim accountsat June 30, 2007 by ADP, Brussels, Copenhagenor Schiphol airports support that view; onlyAeroporti di Roma SpA (AdR; BBB/Watch Neg/A-2) is showing a negative evolution. The disposalof ADR Handling and Italy’s 2007 budget lawimpacted AdR’s reported EBITDA, which wasdown 2.9% against the first semester of 2006.Without this, EBITDA would have grown by3.4%.

Increased security and utilities costs couldhamper EBITDA growth, however, particularly ifrising costs are not offset by sufficient traffic andrevenue growth or cost control. Brussels Airportreported a strong 14% EBITDA growth in its2007 interim accounts, illustrating management’sability to cut operating costs; not all airports havesuch a track record and pressures could rise in theshort to medium term for some of them.

In some European regional airports (notably inthe U.K.) aeronautical revenue is set to growmore slowly than passenger volume in the future,reflecting price incentives offered to grow trafficlevels and the increasing proportion of low-costtraffic. This is due to smaller airports increasinglycompeting with more established regional hubs,as well as a continuing shift in market segmentsresulting in a growing reliance on low-cost traffic.Aeronautical yields per passenger have actuallystarted to decline at Manchester Airport GroupPLC (MAG; A/Stable/--) and the same couldhappen at BIA due to the company’s growingexposure to low-cost traffic and aggressive pricingcompetition. So far, decline in aeronauticalincome has been offset by the resilience ofnonaeronautical income. That might not alwaysbe the case, though, and ultimately steady cashflow generation could be at risk.

Most airports have benefited from increasingrevenues and profits from their real estate-relatedbusinesses in the past years. Future contributionsfrom that segment could shrink or prove lessbuoyant than in the past if the business andcommercial real estate markets stabilize or declineafter several years of sustained growth. We willcontinue monitoring airports’ strategies in realestate, its stability as a revenue source, and if anyproperty development risks are being taken thatwe would consider as weakening the airport’sbusiness risk profile.

Governance and financial aspects paramount forfuture ratings stabilityThe rating implications of overall higherprofitability and stronger internal cash flowgeneration will depend on the use shareholdersmake of additional cash flow: The funding ofcapital spending or capital structure improvementwill be neutral to positive from a creditperspective. Conversely, increasing distributionpayout or M&A activity could put some pressureon the ratings.

A clear example of that is Brussels Airport.Profitability and cash flow generation have beenon the rise following the 2005 privatization, butwe lowered the rating to ‘BBB’ from ‘BBB+’ inJune 2007, following a significant specialdistribution of €310 million to shareholders(subject to meeting certain performance hurdles).As the company was operating under a financingstructure limiting extraordinary dividends,the shareholders had to make a recapitalization torepay existing debt in order to make their distribution.

Looking ahead, it is crucial that airportsmaintain good credit quality and access toexternal funding for their capital expendituresand refinancing needs. In this respect, not only dooperational and financial performance matter but ownership and governance are also key credit factors.

Increasingly complex structures are being put inplace in order to extract money from the airportoperating companies for distribution and/orrefinancing of acquisition debt, due to a spike ininvestor interest in acquiring airports. Standard &Poor’s rigorously examines ownershiparrangements and changes so as to measure thedebt obligations that are, directly or indirectly,supported by an airport’s operations. In June



2007, the ‘BBB/A-2’ ratings on AdR were placedon CreditWatch with negative implications. Theplacement reflected the growing short-term risk toAdR’s credit quality posed by the--ultimatelysuccessful--proposal by Gemina SpA (not rated)to buy out Macquarie Airports’ (Map)(BBB/Stable/--) 45% stake in AdR. Now thatGemina indirectly owns a 96% stake we willreview the new ownership structure, focusingparticularly on the now single, dominatingshareholder. We will also evaluate any revisions toAdR’s business and financial strategies.

Governance and financial policies areincreasingly important considering thereleveraging that has taken place in the airportindustry over the past few years; in most airportsfinancial flexibility is weak. In addition, someairports need to strengthen their financial profiles or complete a refinancing to maintaincurrent ratings.

Regulation will remain a long-term rating driverOne key factor to stable credit quality is torecoup short-term operating and long-term capitalcosts, which speaks to regulation. 2007 hasalready brought some regulatory changes andmore are on the agenda with several regulatoryreviews of airport charges in progress. In anyevent, the way in which the regulators allowairports to fund construction and remuneratetheir investments will remain an important rating factor.

The Competition Commission’s report to theU.K. Civilian Aviation Authority (CAA),published Oct. 3, 2007, proposes price controls atBAA’s primary airport facilities at Heathrow andGatwick that are not materially different from theCAA’s December 2006 initial proposal. The reportitself does not compromise BAA’s ability toexecute a proposed corporate securitizationrefinancing, including the refinancing of BAA’sexisting bonds into an investment-grade ring-fenced entity. However, the proposed pricecontrols are likely to affect the timetable fordoing this, and, if the initial proposals remainunchanged, the overall amount of debt eventually

placed into the ring-fence structure. Firmproposals for the new price controls will not berevealed for the five-year period from April 2008-2013 until November 2007.

On July 30, 2007, the Irish Commission forAviation Regulation published its final decision onthe maximum level of airport charges that may beset at Dublin Airport for 2006-2010. Thecommission decided not to increase the cap onairport charges at Dublin until 2010. Theregulator made it clear that the financialsustainability of the airport (one of the regulator’sthree main duties) can be achieved with an IGrating (high ‘BBB’ category), and, therefore,maintaining the current ‘A’ rating is not part of itsstatutory duty. However, airport passengercharges are likely to rise 22% between 2010 and2014. The price rise is aimed at helping DAA topay for Terminal 2 and related projects. As thecost can only be recovered when the terminal isoperational, DAA will have to borrow asignificant amount to pay for the investmentprogram. Standard & Poor’s will be reviewingDAA’s business plan in the next few weeks toassess the impact of the new debt on the rating.

The ratings and outlook on ADP remainedunchanged in July 2007 following the decision bythe Conseil d’Etat (France’s highest administrativecourt) to cancel the 2006 tariff increase chargedto carriers last year, on the grounds that thecompany did not supply adequate financialinformation to the consultative committee. Thedecision did not call into question the level oftariffs itself or imply repayment by ADP of thecorresponding amounts. ADP will have to applyagain to the consultative committee to validatelast year’s tariff increase, as well as tariffs decidedfor 2007. Importantly, on April 25, 2007, thecourt had confirmed the validity of the five-yearregulatory contract between ADP and the state,paving the way to implement annual tariffincreases of up to 3.25% plus inflation until2010. On that basis, we expect ministerialconfirmation of previously accepted 2006 and2007 tariff increases in the course of 2007. ■


Major Rating Factors

Strengths:■ Excellent competitive position as the

dominant U.K. airport operator and the key hub in Europe

■ Strong cash-generative business■ Diversification through ownership of a

portfolio of airports assets■ Expected continued supportive regulatory

environment and government policies

Weaknesses:■ Currently highly leveraged finance structure

■ Major capital expenditure program resulting in steady negative free cash flow

■ Forecast gradual increase in leverage, which will reduce financial flexibility


RationaleThe ratings on U.K.-based airports operator BAALtd. are supported by the company’s excellentbusiness risk profile. BAA benefits from itsownership and operation of a portfolio of keyU.K. airports catering for a diverse mix ofpassengers, and from supportive regulation andgovernment policies. In addition, the key strategicposition of its main asset, London HeathrowAirport, as a hub airport supports the company’scompetitive position, while its capacity constraintsare expected to ease gradually with the opening ofTerminal 5 (T5) at Heathrow and the ongoingcapital program. The ratings are constrained byBAA’s weakened financial profile, which reflectsthe company’s debt-funded capital program andlimited financial flexibility.

BAA was delisted following its effectiveacquisition by Airport Development andInvestment Ltd. (ADIL) (a consortium led byGrupo Ferrovial S.A.) on Aug. 15, 2006. Thecompany was renamed BAA Ltd. in November2006. Work is underway for the ultimatefinancing structure, which is expected to concludetoward the end of 2007. The ring-fencingstructure to be implemented under the financingwill be key, as--given existing debt and acquisitiondebt at ADIL--the ratings on a consolidated basiswould be in the ‘BB’ category.

In the first six months of fiscal 2007, BAA’spassenger growth slowed to 0.5%, reflecting theimpact of the tightening of security measures anduncertainty over further terrorist attacks.

Higher pension and security costs as well as alower retail income per U.K. passenger limitedprofitability and cash flow growth to lower-than-expected levels in the 12 months to December2006, with the adjusted EBITDA margin--at41.6%--lower than in previous fiscal years (about45%). Adjusted funds from operations (FFO) to

debt and FFO interest coverage over the sameperiod, at 10.6% and 2.7x, respectively, were,however, similar to those at fiscal year-end March2006 (10.8% and 2.8x, respectively).

The ongoing CreditWatch status reflectsuncertainties about the ultimate financingstructure, which is expected to allow existingbonds to achieve a rating that is the same orhigher than the corporate credit rating. Althoughthe transaction is taking more time than originallyanticipated in 2006, it has been progressingsatisfactorily so far. Standard & Poor’s RatingsServices expects to resolve the CreditWatchplacement by the end of 2007. If, as currentlyexpected, all rated debt migrates to a new,investment-grade structure, the corporate creditrating would be withdrawn. In the event that thelong-term financing strategy that ADIL iscontemplating is not implemented, the ratings onBAA could fall to the ‘BB’ category, based onconsolidated debt (including ADIL’s debt).

Liquidity BAA’s liquidity is good, reflecting strong cashflow generation. At Dec. 31, 2006, available banklines and cash in hand combined was £2.135billion (£1.764 billion at the end of June 2007).BAA is a joint obligor with its 100% parent ADILon a £2.25 billion facility maturing in April 2011.At Dec. 31, 2006, £200 million had been drawnon the facility. In addition, overdraft facilities of£25 million were available. These facilitiescomfortably cover BAA’s negative free operatingcash flow for 2007 (mainly due to capitalexpenditure investments) and forthcoming debtmaturities. At June 30, 2007, BAA’s short-termdebt maturities were modest, with only one bondmaturing in the next 12 months--the convertible£424 million notes due in April 2008, which are100% owned by ADIL.

BAA LTD.


Publication Date:

Aug. 21, 2007

Issuer Credit Rating:BBB+/WatchNeg/NR

Primary Credit Analyst: Alexandre de Lestrange, Paris, (33) 1-4420-7316

Secondary Credit Analyst: Michael Wilkins, London, (44) 20-7176-3528


Business DescriptionBAA’s core business is the ownership andoperation of seven U.K. airports, including itsthree designated airports: Heathrow (includingthe Heathrow Express rail link), Gatwick, andStansted, which serve London and southeastEngland, and together generate about 90% ofgroup revenues. The company’s other airports areSouthampton in southern England, and Aberdeen,Glasgow, and Edinburgh in Scotland.

BAA also operates and owns a majority stake inNaples airport in Italy, has ownership andoperational interests in six Australian airports,and runs retail or management contracts at threeairports in the U.S. In addition, the companyowns and operates World Duty Free and propertymanagement business BAA Lynton, although thisoperation is up for sale. Airport-related businesses(excluding duty free) account for more than 70%of total revenues.

The ultimate parent company of ADIL in theU.K. is FGP Topco Ltd., a company owned byFerrovial Infraestructuras S.A. (62%), Caisse dedépôt et placement du Québec (28%), and BakerStreet Investment Pte Ltd. (10%), an investmentvehicle controlled by GIC Special Investments.

Rating ApproachSince the June 2006 downgrade when ADIL’soffer for shares and convertible bonds becameunconditional, we’ve adopted a forward-lookingapproach to the ratings. The ratings will remainon CreditWatch pending final execution of ADIL’sproposed permanent financing strategy followingthe acquisition. The ‘BBB+’ ratings reflects ourexpectation that existing bondholders will bemigrated to a special-purpose vehicle, allowingBAA’s existing debt to be rated at least at thecurrent rating level.

The ring-fencing structure should also isolatethe future credit quality of the regulated airportcompanies backing the new financing from ADILand its ultimate parents.

Business Risk Profile: Very StrongCompetitive Position, Solid Operations,Supportive Regulation, High ProfitabilityExcluding industry event risk, we expect BAA’sbusiness risk profile to remain stable and supportive.

BAA’s excellent business profile reflects itsstrong competitive position owing to: its location;

ownership of Europe’s main hub airport; diversityof airlines, destinations, and passengers; soundtraffic growth prospects in the U.K.; and asupportive regulatory environment. The businessprofile is also supported by the diversificationbenefits of the company’s ownership of sevenU.K. airports, each with different trafficcharacteristics. These strengths are only partlytempered by current capacity constraints atHeathrow and Gatwick and operationalchallenges pending the completion of the capitalexpenditure program.

Competitive positionBAA is the largest airport operator in Europe,handling about 148.0 million passengers (on arolling basis) at its U.K. airports in the 12 monthsto June 2007. The company’s strong passengerpotential derives from its large and wealthycatchment area and London’s position as Europe’smajor financial center and a leading touristdestination. A further competitive strength is thatall three London airports are linked to the centerof London via high-speed rail links. BAA’s mainhub, Heathrow, is Europe’s largest airport, with67.0 million passengers in the 12 months to June2007. Gatwick is also an important European hubairport, handling 34.5 million passengers in thesame period.

BAA’s Heathrow and Gatwick airports competewith Europe’s other major international hubairports for connecting passengers only, mostnotably Frankfurt, Amsterdam Airport Schiphol,and Paris Charles de Gaulle (CDG). Capacityconstraints at Heathrow and Gatwick havesomewhat affected their competitive positions. Inaddition, the number of destinations served byHeathrow and Gatwick lags behind that of CDG,Frankfurt, and Schiphol. BAA, however, hashigher frequency service to major destinations,which is an important factor for both travelersand airlines because it gives a choice ofconnections. In addition, Heathrow and Gatwickare less exposed than their peers to competitionfor transfer passengers or to any one particularairline, as both constitute a smaller proportion of traffic.

Despite the additional capacity to be providedby T5 from 2008, Heathrow’s traffic is expectedto grow more slowly than the expected long-termgrowth average in the U.K. and for otherEuropean hubs. This is due to runway capacity



constraints. Although the U.K. Aviation WhitePaper “The Future of Air Transport” (the WhitePaper), published in December 2003, proposes theconstruction of a third runway at Heathrow andadditional terminal capacity, this is only expectedby 2015-2020 if environmental conditions aremet and the planning process runs smoothly.

Aeronautical activityBAA is forecasting average passenger trafficgrowth for its three designated airports of 2.8%per year over the 2007-2018 period. This is belowthe expected natural growth rate in England of4.5% to 5.0%, reflecting capacity constraints atthe London airports. Industry events, erosion ofpassenger confidence, and a weak economicclimate, could result in lower-than-expectedpassenger growth. Our long-term scenario isannual passenger growth of about 2%.

Historical trends have demonstrated thestability of aeronautical activity at BAA’s airportsand the increasing resilience of passenger demandbehavior to external shocks. This supports BAA’sbusiness profile. BAA has a record of more than40 years of almost continual traffic growth.During this period, only the years following thefirst oil crisis in 1974, the 1991 Gulf War, and theevents of Sept. 11, 2001 showed traffic decreases.Nevertheless, with the exception of 1991, whentraffic decreased by 7%, the rate of passengervolume decline was in the low single digits andwas short lived.

Since the beginning of the 2003-2008regulatory period, traffic performance at thedesignated airports has been mixed. BAA’sdesignated airports underperformed theregulatory assumptions in the fiscal years endedMarch 31, 2006, and Dec. 31, 2006 (thecompany’s fiscal year-end was changed during2006; see “Accounting” section), andoutperformed the U.K. Civil Aviation Authority’s(CAA) assumptions in 2005. Based on first-halftraffic figures, 2007 is likely to be below theCAA’s assumptions.

In the first six months of fiscal 2007, traffic atBAA’s regulated airports was stable comparedwith the same period of the previous year, after adecline of 0.6% in June 2006. Performance atgroup level was stronger, with passenger growthat 0.5% (below the 1.1% increase in the 12month rolling period to June 2007), thanks to the

performance of Southampton and the Scottishairports, which saw growth of 3.2% and 3.5%,respectively, over the period. The recent attemptedterrorist attack at Glasgow airport contributed toa fall of 2.4% in June 2007, as more than 60% offlights were cancelled or diverted when the airportwas temporarily closed in the immediateaftermath of the incident. Less than 24 hoursafter the incident the airport was reopened andoperating a full flight schedule.

A diversified airline, destination, and passengermix supports traffic stability at BAA’s airports.Customer concentration and dependence on thelower rated airline sector are perceived asweaknesses for airports in general, whencompared with gas and water utilities.Nevertheless, airports with strong competitivepositions are partially insulated from this risk, asthe strength of routes is key for traffic stability. Ifthere is sufficient demand for a particulardestination, it is expected that a failing airlineserving that route would be substituted. AlthoughBAA’s four largest customers contribute aboutone-half of its designated airports’ passengertraffic (the revenue contribution is lower),customer concentration is not perceived as acredit risk, particularly at Heathrow, wheredemand for slots exceeds supply. Of the hubairport operators rated by Standard & Poor’s,BAA has the lowest exposure to its flag carrier.For the nine months ended December 2006, 27%of total passenger traffic came from BritishAirways PLC (BBB-/Stable/--) (Heathrow 41%,Gatwick 21%). In comparison, Air France-KLMrepresented more than 50% of passengers atAeroports de Paris (AA-/Stable/--) and more than60% at Schiphol (N.V. Luchthaven Schiphol andSchiphol Nederland B.V.; AA-/Negative/--).

Each of BAA’s larger airports caters for differentsegments of the aviation market. Thisdiversification is supportive of BAA’s businessprofile because the negative effects of a downturnin one segment can be offset by strongperformance in others. Heathrow is the largesthub in Europe, and almost all carriers arescheduled rather than charter, while Gatwick isthe main U.K. charter airport, with a growinglow-cost carrier presence. Stansted is an originand destination airport and the U.K. center forthe low-cost airline business. Stansted’s rapidgrowth rates over the past 10 years result from



the rapid expansion of low-cost carriers Ryanairand easyJet. The Scottish and Southamptonairports have a mixture of carrier types.

BAA’s traffic base is relatively diversified acrossdifferent markets. At the three London airports,the major destinations are Europe and NorthAmerica, which accounted for 70% and 13% oftotal traffic in 2006, respectively. A balancedbreakdown of business and leisure travel betweenU.K. and overseas residents supportsdiversification of the passenger mix.

Revenue diversity and stabilityBAA’s revenue stability is directly linked to thestability of traffic and a tested tariff-setting regime(see “Regulation and government policy”). A highproportion of revenues also comes from retailactivities. The company conducts a largepercentage of its commercial activity directly.About 45% of retail revenues come from theWorld Duty Free franchise, which is directlymanaged by BAA. This direct involvement is not anegative factor because airport retail activities,particularly airside, are more stable than high-street retail.

BAA recognizes revenues and costs associatedwith the World Duty Free operations, and soretail revenues represent about 35% of totalrevenues. This contrasts with other Europeanairports, where commercial revenues, excludingproperties, represent 20%-30% of the rated hubs’revenue structure.

Regulation and government policy: London airportsIn 2007, BAA will be reviewed by the U.K.Competition Commission (CC) in two parallelreviews.

The regulatory review for the period from2008-2009 to 2012-2013 (Q5, or the fifthquinquennium) will consider BAA’s past andforecast future performance, assess its costs ofcapital, make recommendations on the price-cap,and determine whether the company, in itsmanagement of the three London airports, hasacted against the public interest.

In a separate process, a review by the Office ofFair Trading (OFT) will investigate the structureof the U.K. airport market.

General principles.The framework for airport regulation in the U.K.is set by the Airports Act 1986, with aviationpolicy determined by the Department forTransport (DfT).

Although the CAA is the primary economicregulator of U.K. airports, the CC has amandatory role as an adviser to the CAA. Theregulatory responsibilities of the CAA and the CCinclude a duty to encourage investment in newfacilities at airports in time to satisfy anticipatedpassenger demand. Unlike other regulators, suchas those in the water industry, the regulator hasno wider responsibility to ensure that BAA attainsa specified credit rating level. It must, however,ensure that the company is able to finance itsactivities. The CAA does not have the power todedesignate an airport; this is held by the DfT.

BAA benefits from strong government supportfor its business as it provides key infrastructurefor economic growth in the U.K. Although thereis no expectation that the government will providefunds to finance airport infrastructure, Standard& Poor’s expects that it and the economicregulator will continue to create conditions forlonger term investment in the expansion ofaviation capacity in southeast England.

The White Paper clarified the government’spolicies regarding airport expansion for the U.K.It emphasized the need for airport operators toinvest in delivering new capacity.

Price-cap mechanisms.Since 1986, the CAA has been required to set afive-year period price control formula fixing themaximum airport charges that may be levied atHeathrow, Gatwick, and Stansted on a stand-alone regulation basis (that is, by reference toeach airport’s own air traffic, costs, and assets).The charges within the price-cap include runwaylanding, aircraft parking, and the departingpassenger charge.

The price-cap is set with reference to forecastsfor traffic volumes, capital investment, operatingcosts, and operating revenues, as well as allowingBAA a reasonable rate of return on itsinvestments. The formula follows a “single-till”approach, where retail and property activitiessubsidize aeronautical activities. To determine theprice-cap, required revenues are calculated basedon the sum of net expenditures, regulatory



depreciation of remunerated assets, and required returns on the average value ofremunerated assets.

Although the CAA has demonstrated flexibilityby allowing BAA to offset revenue losses causedby external events, such as the loss of duty freerevenues in 1999, BAA does not benefit fromregulatory protection in a situation of financialdistress caused by financing decisions.

Price control review: initial proposals. The formal process for setting the charges for Q5began in December 2005 when the CAApublished its policy issues paper for consultation.BAA then rejected the CAA’s December 2006initial regulatory proposals as failing toincentivize the company to invest at its airports.The next stage in the process sees a review by theCC before the CAA sets prices in early 2008.

The CAA has proposed that the allowedweighted average cost of capital (WACC) shouldbe cut to 5.90%-6.20% for Heathrow and6.30%-6.70% for Gatwick, which would be amarked reduction from the 7.75% allowed in2003. This change could arguably prompt ADILto lower its intended capital program. Such largemovements between quinquennia may well resultin rating volatility for BAA in the future.Significantly, the CAA has stated that it will notreconsider the level of WACC in view of the taxshield provided by the higher leverage ADILintends to implement, or adopt a higherproportion of debt in the WACC calculation. Thisis a credit positive for BAA.

The CAA has put forward indicative ranges forcaps on airport charges at Heathrow of the retailprice index (RPI) plus 4.0%-8.0%, comparedwith the current rate of growth in price-caps ofRPI plus 6.5%. For Gatwick airport, the CAA hasproposed a price-cap ranging from RPI minus 2%to RPI plus 2%, compared with the current rateof growth of RPI plus 0%. Standard & Poor’sdoes not consider that these changes will affect itsanalysis. Importantly, Heathrow will beauthorized to continue implementing high feeincreases. This is a credit strength, given thatHeathrow remains the largest airport in the U.K.in terms of passengers, and given the significantcapital expenditure plan underway.

The price control proposals suggested by theCAA are now with the CC. Given the CC’s trackrecord, we expect it to continue the supportiveregulatory regime for investment that it delivered

in the fourth quinquennium.Finally, the CAA has recommended that the

government should consider removing therequirement for the CAA to set price controls atStansted, and instead dedesignate the airport. Intheory, BAA could therefore implement highercharges, but this may prove difficult consideringthe airport’s focus on low-cost carriers. Thisdecision reflects the CAA’s acknowledgement thatBAA currently charges below the regulator’s price-cap, and the view that Stansted does not havesignificant market power. The dedesignation isviewed as mildly positive overall, depending onthe future competitive position of Stansted andhow “stranded asset risk” is mitigated. Weunderstand that ADIL continues to see Stanstedairport as a core asset.

The potential removal of Stansted from theregulated asset base (RAB) is unlikely to affect theproposed securitization of BAA, given that theairport only accounts for about 9% of thecombined RAB of £11.3 billion (at March 2007).About £10.3 billion of regulated assets willremain to back the securitization financing, whichshould ensure that the transaction goes forward.

Standard & Poor’s recognizes the importance ofthe method by which Stansted’s potentialdedesignation will be accounted for within thering-fence structure.

Office of Fair Trading and CompetitionCommission investigation. The OFT launched an investigation into the U.K.airports sector in 2006. In December 2006, itreported its preliminary findings that BAA’sownership of its airports, the system of economicregulation of airports in the U.K., and capacityconstraints combine to prevent, restrict, or distortcompetition and referred the supply of airportservices by BAA within the U.K. to the CC. Thisreview is expected to take up to two years tocomplete. On Aug. 9, 2007, the CC released astatement of issues it would look at following thereference made to it by the OFT in March 2007.The CC declared it would now determine whetherthere are any features of the market that prevent,restrict, or distort competition, and, if so, whatremedial action might be taken. The CC expectsto publish for consultation in the early part of2008 a document setting its “emerging thinking”on all the key issues. It currently aims to publishits provisional findings around this time next year.



BAA has already been subject to a number ofgovernment sponsored studies of airports, whichconcluded previously that it would not bedesirable to break up the airports in the southeastof England. The OFT referral includes thedesignated airports that are subject to an RAB-based regulation with price-caps designed tooffset their monopoly characteristics. We believethat a breakup would be negative from a ratingperspective, as it would reduce the supportiveportfolio diversification stemming from operatingseveral airports with different airlines, traffictypes, and capital cycles. We would expect ADIL’sproposed permanent financing to factor in any breakup of the designated airports. The potential rating impact would depend in part on the allocation of BAA’s existing debtpostbreakup.

Nondesignated airport regulationBAA’s nondesignated airports are subject either tomuch lighter economic regulation or no economicregulation and are therefore free to set airline charges directly with the customers (theairline users).

OperationsThe company has strong aviation and retailoperations, as reflected in its strong operatingmargin compared with some of its peers. Externalconsultants used by the CAA for the ongoingregulatory review have not raised any severeissues in terms of operating or capital spending.They have, however, suggested ways to furtherimprove operations.

BAA has a good track record for capitalprojects. Phase 1 of T5, which incorporates themain terminal building and Satellite 1, wasapproximately 90% complete at Dec. 31, 2006.The project continues to make good progress andthe development remains on budget and onschedule to open in March 2008. To incentivizefurther investment at Heathrow and Gatwickairports, the CAA is proposing that all of the £6billion capital expenditures incurred over the2003-2008 period be factored into the RAB and remunerated.

Congestion and queuing times at BAA’s airportshave been the subject of severe public discontentin recent months. To alleviate this, BAA is in theprocess of recruiting 1,400 extra security guardsand opening 22 new security lanes across its sevenU.K. airports. The company is committed to

reducing queues to five minutes or less for 95%of the time.

Capacity shortage, which is a negative ratingfactor, is being addressed. Existing planningapprovals provide for approximate passengertraffic growth at Heathrow (including T5) to 90million (55 million capacity at the moment),Gatwick to about 40 million, and Stansted toabout 25 million.

BAA’s additional projects are to knock downTerminal 2 and replace it with a new terminal,Heathrow East. The terminal would not increasethe capacity of the airport but would replaceoutdated buildings. Stansted Generation 2includes the provision of a second runway andterminal, with initial capacity for about 10million passengers per year.

The current estimate of the net cost of theblight and compensation schemes for those peoplemost affected by the Stansted development is upto £100 million. The White Paper also commitsBAA to offering noise mitigation measures.Payments under the noise schemes are estimatedat £7 million per year for the next four years andup to £350 million over the next 29 years forblight schemes.

BAA has interests in various airports outsidethe U.K. The company also owns 50% of AirportProperty Partnership, a property joint venturewith Morley Fund Management that is in theprocess of being disposed as it is considerednoncore activity. Budapest Airport was sold to aconsortium led by Hochtief in June 2007.

ProfitabilityAirports tend to have high operating marginsowing to growing revenues, a high proportion offixed costs, and relatively low staff levels. BAAhas demonstrated stability of earnings and cashflow despite adverse events. Passenger numbers,tariff changes, and retail activities are the maindrivers of revenue growth. Although thecompany’s operating margins will be subject topressure in the years immediately following theopening of its new terminal at Heathrow, BAA’snew owners expect profitability to eventuallybenefit from the additional capacity provided by T5.

As a mechanism to encourage BAA to carry outits proposed investments, the CAA is consideringmaintaining the price profiling (or revenueadvancement), which was incorporated in theHeathrow price review for 2003-2008. This



allows a proportion of the costs associated with afuture investment (depreciation) to be recoveredbefore that new investment comes into operation.In addition, assets are remunerated during thecourse of construction at the regulatory cost ofcapital. This mechanism has significantly reducedrisk in the T5 investment. Although the recoveryof 75% of incremental security costs incurred inthe event of additional security requirements(subject to minimal costs) being introduced by thegovernment is viewed favorably, this is lower thanin previous regulatory reviews.

Although historically BAA has achieved orbeaten operating cost forecasts assumed in theregulatory review, the group has underperformedin the current regulatory period due to new legalsecurity requirements, market-driven costs such asutilities and business rates, and White Paperobligations on noise and blight. In the 12 months

to December 2006, the adjusted operating marginbefore depreciation was 42.1%. In previous years,margins have ranged close to or above 45%.Operating income in 2006 was affected byreorganization costs, bid advisory costs, staff-related costs due to the change in ownership, andcosts incurred to ensure that T5 becomesoperational in March 2008. An increase inpension contributions put further pressure onoperating costs.

Financial Risk Profile: High LeverageReflects Capital Returns, ExpectedReleveraging After Takeover, And WeakCredit MetricsBAA’s weakened financial profile reflects thecompany’s debt-funded capital program andlimited financial flexibility.


--12 months to Dec. 31, 2006--

BAA Ltd. amounts

Operating Operating Operating Cash flow Cash flowShareholders' income income income Interest from from Capital

Debt equity (before D&A) (before D&A) (after D&A) expense operations operations expenditure

Reported 6,392.0 6,339.0 972.0 972.0 702.0 159.0 558.0 558.0 1,106.0

Standard & Poor's adjustments

Operating leases 895.9 -- 72.0 53.8 53.8 53.8 18.2 18.2 16.9

Postretirement benefit obligations 162.0 -- 4.0 4.0 4.0 -- (4.9) (4.9) --

Additional items included in debt 192.0 -- -- -- -- -- -- -- --

Capitalized interest -- -- -- -- -- 137.0 -- -- --

Share-based compensation expense -- -- -- 5.0 -- -- -- -- --

Reclassification of nonoperating income (expenses) -- -- -- -- 29.0 -- -- -- --

Reclassification of working-capital cash flow changes -- -- -- -- -- -- -- 48.0 --

Minority interest -- 10.0 -- -- -- -- -- -- --

Other -- -- 31.0 31.0 (40.0) 50.0 192.0 191.0 399.0

Total adjustments 1,249.9 10.0 107.0 93.8 46.8 240.8 205.3 252.3 415.9

Standard & Poor's adjusted amounts

Cash Operating flow Funds

income Interest from from CapitalDebt Equity (before D&A) EBITDA EBIT expense operations operations expenditures

Adjusted 7,641.9 6,349.0 1,079.0 1,065.8 748.8 399.8 763.3 810.3 1,521.9*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 beforeD&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.

Table 1 - Reconciliation Of BAA Ltd. Estimated Amounts With Standard & Poor's Adjusted Amounts (Mil. £)*


AccountingBAA changed its reporting date to Dec. 31(previously March 31) to align with GrupoFerrovial S.A., its ultimate majority shareholder.Auditors issued an unqualified audit report forthe last fiscal period.

The consolidated financial statements for BAALtd. (formerly BAA PLC) are prepared inaccordance with IFRS and under the historicalcost convention, with the exception of investmentproperties, available-for-sale assets, derivativefinancial instruments, and financial liabilities thatqualify as hedged items under a fair value hedgeaccounting system.

During the course of 2006, BAA changed itsaccounting treatment for joint venture entities toproportionately consolidate the financialperformance for the reporting period and thefinancial position at Dec. 31, 2006 (previouslyjoint venture entities were equity accounted). This change in policy has no impact on net profit or reserves.

The financial information presented in thisreport is based on the segregation of the fourthquarter of the fiscal year ended March 2006 fromthe financial report for the nine months toDecember 2006, and reflects the balance sheet atDecember 2006. Comparability with the fiscalyear ended March 2006 must be considered inview of the three-month crossover.

The main adjustments to the company’sreported debt figures concern leases,postretirement obligations (£192 million), andcontingent liabilities.

BAA has changed the disclosure of its leaseobligations under IFRS. Comparing the previous2004/2005 accounts with the 2005/2006accounts, the amounts payable in 2005/2006 didnot correlate to the previous disclosure or theactual charge in the accounts. The accounts forthe year to December 2006 (with restated figuresat March 2006) show a large lease liability. Forcomparison purposes, the adjustment of futurelease obligations for the net present value at 6%has also been made for the years ended March2005 and March 2006.

Our adjustments to operating income (beforeD&A) and EBITDA (see table 1 on previouspage) reflect three key components: the operatingincome contribution for three months (£216million) less the gain on investments (£206

million) plus the derivatives losses (£21 million)recognized in operating income. The adjustmentsto EBIT reflect the same items along with threemonths of depreciation (£81 million) and interestincome (£10 million). The adjustments to interestexpense, cash flow from operations, funds fromoperations, and capital expenditure relate entirelyto the three-month pro forma adjustment.

Corporate governance/Risk tolerance/Financial policiesADIL’s strategy and intention is to migrateexisting bondholders into an investment-gradering-fenced entity backed by BAA’s threedesignated airports. BAA’s other airports in theU.K. (Southampton, Aberdeen, Glasgow, andEdinburgh) will remain outside of the ring-fence and are expected to be financed on a stand-alone basis.

We expect the future ring-fenced structurefinancing to be supported by:

• A strong overall covenant package;• Limitations on additional debt and business

activities, such as a rating confirmation requirement for acquisitions above certain thresholds (the latter creating certainty that the revenue profile will not change);

• Restrictions on upstream distributions outside the ring-fence;

• Likely achievable fixed and floating charges on the assets of the three designated airports; and

• The stability provided by BAA’s designated airports business.

BAA’s main financial policy objectives are: • To maintain a minimum of 70% of existing

debt on fixed rates.• To use foreign currency forward contracts to

hedge capital expenditure in foreign currency once a project is certain to go ahead. At December 2006, there were no significant unmatched exposures.

• To ensure that the company is not exposed to excessive refinancing risk in any one year.In addition:

• Covenants are standardized wherever possible and are monitored on an ongoing basis. BAA continues to comply with all borrowing obligations and financial covenants.



The treasury function is not permitted tospeculate in financial instruments. An interimdividend of £165 million was proposed for theyear ended March 31, 2006, and was paid duringthe nine-month period to Dec. 31, 2006. Further,an interim dividend of £78 million was paid toADIL out of postacquisition profits on Nov. 11,2006. Also, BAA made a £114 million loan toADIL in 2006.

Cash flow adequacyThe high operating margins and the relativelystable and predictable cash flows produced byBAA’s diversified airports are a significant credit strength.

The £9 billion-plus 2007-2018 investmentprogram for the three southeast England airports

will continue to drive BAA’s financial risk profilefor the next 10 years. Standard & Poor’s expectsfree cash flow generation to be negative duringthis period. From a credit perspective, the abilityto recover the cost of investment in the course ofconstruction is positive as it allows BAA to collectrevenues associated with long-term projects beforecompletion, boosting operating cash flow and,therefore, reducing the impact of the long-terminvestment plan on the company’s financialprofile. BAA has publicly stated that investmentscontemplated in the White Paper will only bemade if future regulatory determinations aresupportive, and if there are appropriate levels ofdemand to support the investment withoutputting the group’s financial robustness at risk.

Adjusted FFO coverage of interest and debt in


--12 months to Dec. 31, 2006-- --Fiscal year ended Dec. 31, 2006--

BAA Ltd.¶ N.V. Luchthaven Schiphol Aeroports de Paris

Rating as of Aug. 13, 2007 BBB+/Watch Neg/NR AA-/Negative/-- AA-/Stable/--

(Mil. mixed currency) GBP EUR EUR

Revenues 2,564.0 1,036.7 2,076.8

EBITDA 1,065.8 440.4 665.1

Net income from continuing operations 463.0 526.9 152.1

Funds from operations (FFO) 810.3 348.6 537.7

Cash flow from operations 763.3 359.3 464.0

Capital expenditures 1,521.9 241.4 712.5

Free operating cash flow (758.6) 117.9 (248.5)

Discretionary cash flow (1,001.6) 62.5 (311.7)

Cash and investments 93.0 257.1 509.2

Debt 7,641.9 1,075.0 2,682.1

Common equity 6,339.0 2,702.8 2,794.6

Adjusted ratios

EBITDA/sales (%) 41.6 42.5 32.0

Operating income/sales (%) 42.1 42.8 32.0

EBIT interest coverage (x) 1.9 5.1 3.7

EBITDA interest coverage (x) 2.7 7.3 5.6

Return on capital (%) 5.0 8.5 8.2

FFO/debt (%) 10.6 32.4 20.0

Cash flow from operations/debt (%) 10.0 33.4 17.3

Free operating cash flow/debt (%) (9.9) 11.0 (9.3)

Debt/EBITDA (x) 7.2 2.4 4.0

Debt/total capital (%) 54.6 28.3 49.0

Ratios before adjustments for postretirement obligations

Operating income/sales (before D&A) (%) 41.9 42.9 30.8

EBIT interest coverage (x) 1.9 5.3 4.0

FFO/debt (%) 10.9 33.8 22.3

Debt/EBITDA (x) 7.0 2.3 3.8

Debt/total capital (%) 54.1 27.6 46.5 *Fully adjusted (including postretirement obligations). ¶Excess cash and investments netted against debt.

Table 2 - BAA Ltd. Peer Comparison*



the 12 months to December 2006 at 10.6% and2.7x were quite similar to those at fiscal year-endMarch 2006 (10.8% and 2.8x, respectively).

The debt-financed acquisition of BAA by ADILand expected refinancing will have a significantimpact on cash flow adequacy measures.Although financial ratios are likely to be weak,they should be interpreted in light of BAA’srelatively low business risk and the transaction’sstructural features. We would expect BAA to fundits future capital investment program in respect ofthe designated airports through further debtissuance from the ring-fenced designated airports,limiting the future cost of debt.

Capital structure/Asset protectionLeverage is forecast to increase as ongoing capitalexpenditure will be debt-financed. Future ratingswill be constrained by an anticipated aggressivecapital structure, moderate debt protectionmeasures, and the ongoing need to raise debt tofinance capital expenditures.

At Dec. 31, 2006, gross unadjusted debt was£6.4 billion, as at March 31, 2006. Adjusted debtto capitalization in the 12 months to December2006 increased to 54.6%, from 53.3% at March 2006.

BAA’s debt structure was adequate at Dec. 31,2006, with 80% of debt maturing in more thanfive years. Of the debt portfolio, 86% was atfixed interest rates.

During the nine months to Dec. 31, 2006,ADIL acquired BAA’s outstanding convertiblebonds (£424 million 2.94% and £425 million2.625%). Unless previously redeemed orconverted, BAA will redeem the bonds at par onApril 4, 2008, and Aug. 19, 2009, respectively.

At year-end 2006, secured debt was marginal at£234 million, out of gross unadjusted debt of£6.4 billion. Structural subordination forunsecured lenders is therefore minimal.

BAA’s long-term bonds benefit from upstreamguarantees from Heathrow, Gatwick, andStansted. Those due in 2016, 2021, 2028, and2031 also carry interest coverage and gearingcovenants, but do not contain negative pledgeclauses. Under the terms of the ADIL senior andjunior finance documents, BAA Ltd., as anobligor, jointly and severally guarantees the ADIL senior and subordinated facilities. Themaximum value of this guarantee is limited by thethreshold at which the financial and othercovenants contained in the existing bonds would be breached.

--12 months to Dec. 31-- --Fiscal year ended March 31--

(Mil. £) 2006 2006 2005 2004 2003

Rating history A/Watch Neg/A-1 A/Watch Neg/A-1 A+/Stable/A-1+ A+/Stable/A-1+ AA-/Negative/A-1+

Revenues 2,564.0 2,313.0 2,115.0 1,970.0 1,909.0

Net income from continuing operations 463.0 531.0 672.0 377.0 374.0

Funds from operations (FFO) 810.3 738.3 732.4 680.0 636.5

Capital expenditures 1,521.9 1,502.2 2,288.9 1,314.6 719.6

Free operating cash flow (758.6) (805.9) (1,597.5) (680.5) (96.1)

Discretionary cash flow (1,001.6) (1,036.9) (1,811.5) (886.5) (294.1)

Cash and investments 93.0 83.5 83.5 890.0 1,156.0

Debt 7,641.9 6,842.7 4,381.7 3,983.9 3,506.1

Common equity 6,339.0 5,982.0 5,623.0 5,018.0 4,575.0

Total capital 13,990.9 12,834.7 10,013.7 9,009.9 8,089.1

EBIT interest coverage (x) 1.9 2.3 3.7 3.2 3.2

EBITDA interest coverage (x) 2.7 3.0 4.7 4.1 4.0

FFO interest coverage (x) 2.7 2.8 3.3 3.9 3.9

FFO/debt (%) 10.6 10.8 16.7 17.1 18.2

Discretionary cash flow/debt (%) (13.1) (15.2) (41.3) (22.3) (8.4)

Net cash flow/capital expenditure (%) 37.3 33.8 22.6 36.1 60.9

Debt/total capital (%) 54.6 53.3 43.8 44.2 43.3

Return on common equity (%) 7.5 9.2 12.6 7.9 8.0

Common dividend payout ratio (unadjusted) (%) 16.8 45.8 33.8 56.2 54.0

Table 3 - BAA Ltd. Financial Summary

The 2012, 2013, 2014, 2018, and 2023, andconvertible bonds contain a negative pledgeclause, meaning that, as long as these bondsremain outstanding, the issuer will not permit itsassets to be pledged in favor of any new bondswith a tenor of less than 20 years, unless thebonds are secured equally. Limited protection isalso derived from a put option, under which bondinvestors can sell the bonds back to BAA ifairport operations cease to be the company’smajor business and if this results in the long-termcorporate credit rating falling below ‘BBB-’.

The £1 billion revolving credit facility wascancelled on Aug. 21, 2006. BAA is a jointobligor with its 100% parent ADIL on a £2.25billion facility maturing in April 2011. At Dec.31, 2006, £200 million had been drawn on the facility. ■




Transaction SummaryStandard & Poor’s Ratings Services assignedcredit ratings to the secured index-linked, securedfloating-rate and secured fixed-rate notes issuedby Channel Link Enterprises Finance PLC, apublic limited liability company incorporated inEngland and Wales.

At closing, the original lenders transferred theoriginal loan and the rights attached to it toChannel Link Enterprises Finance PLC.

The ‘AAA’ ratings on the class G notes reflectthe unconditional guarantee provided by AMBACAssurance U.K. Ltd. (AMBAC) for the class G1and G4 notes, FGIC UK Ltd. (FGIC) for the classG2 and G5 notes, and Financial SecurityAssurance (U.K.) Ltd. (FSA) for the class G3 andG6 notes. The underlying rating assigned to theclass G1, G2, G3, and G4 notes is ‘BBB’. Inaddition, the rating assigned to the class A notesis ‘BBB’.

The ‘BBB’ ratings reflect, among other things:• For the first time, the senior-loan leverage

resulting in sustainable debt levels for the company under steady operations;

• Forecasted cash flow generation, which should provide some cushion for slowdowns limited in magnitude and in time;

• The concession to operate the tunnel, which runs for another 80 years until 2086;

• Strong operating margins: the EBITDA margin for Eurotunnel has consistently been over 50% since 1999; and

• Limited capital expenditure requirements resulting in positive free cash flow.

On the issue date, the issuer also issuedfloating-rate liquidity notes to fund the liquidity

reserve accounts. The payment to the liquidityreserve accounts in case of funds withdrawn, andthe interest and principal on the liquidity notes,rank senior to the class G and class A notes. Therating assigned to the sterling and euro liquiditynotes is ‘A-’. The higher ratings assigned to theliquidity notes reflect, among other things, theirseniority in the waterfall and their better recovery potential.

Notable FeaturesTo rate the notes, Standard & Poor’s applied amixed approach combining corporate/concessionfinancing to reflect the borrower’s characteristics(Eurotunnel Group, an infrastructure provideroperating under a concession) and structuredanalysis (reflecting the repackaging of theborrower’s loan).

The analysis does not rely on looking through apost-insolvency scenario, as the underlying ‘BBB’rating on the notes is below Standard & Poor’sestimate of the borrower’s business risk, the latterclassified as satisfactory to strong (BBB+/A-). Assuch, this is not a standard corporatesecuritization cash flow transaction. In standardcash flow corporate securitizations, where therating on the notes is typically above the businessrisk of the underlying entity, noteholders normallyrely on enforcement of security (such as step-inrights and the appointment of a receiver) to takecontrol over the company in the event ofinsolvency, and repay the rated debt.

For Channel Link Enterprises Finance PLC,Standard & Poor’s analysis does not rely on thepost-insolvency enforcement of the security. There is no right to appoint a receiver in Franceas there is in the U.K. As regards step-in rights,

CHANNEL LINK ENTERPRISES FINANCE PLC


Transaction Key Features

Closing date Aug. 20, 2007

Collateral A permanent facility to the Channel Tunnel Group Ltd. (sterling tranches) and France Manche S.A. (euro tranches). The U.K. security includes first-fixed and first-floating charges over freehold and leasehold properties, charges and assignment over the principalproject agreement and insurances, charges over bank accounts and intellectual properties, and a first-floating charge over all present and future assets. In France, security includes security over debt, pledges over bank accounts, trademarks, other intellectual property, and over shares in the Eurotunnel group members in France.

Countries of origination U.K. and France

Sterling floating-rate liquidity notes (Mil. £) 175

Euro floating-rate liquidity notes (Mil. € ) 160

Transaction Summary

Publication Date:

Sept. 19, 2007

Primary Credit Analysts:Alexandre de Lestrange,Paris, (33) 1-4420-7316

Michela Bariletti, London, (44) 20-7176-3804



Standard & Poor’s notes that, although there arearguments to sustain the view that the lenders’right of substitution under the concession shouldremain enforceable in the insolvency of theborrower, this has never been tested and thereforeis not a determinant of the rating. Hence, therating approach is closer to a concession orcorporate financing than a traditionalsecuritization.

The rating approach is also reflected in thetransaction’s leverage. Compared with traditionalcorporate securitization transactions, the leverageis high given Eurotunnel’s business risk, and thelegal and structure features. Conversely, otherinfrastructure operators can bear similarleverages; for instance, Autoroutes Paris-Rhin-Rhone’s (APRR) facility is rated ‘BBB-’ with amaximum consolidated leverage of about 11.2x(in 2006) and minimum DSCR of 1.31x (in2012). APRR is the third-largest toll roadoperator in Europe, with a network of 2,205kilometers in service, and is under concessionuntil 2032.

In the project finance market, transactions withhigher leverages have reached investment grade.For instance, 407 International Inc. (a toll road inCanada) had total debt/EBITDA of about 12.7xat the end of 2006, including subordinated debt.The senior rating is ‘A’, while the rating is ‘BBB’for subordinated debt. The subordinated debt wasstripped of most of its covenants (no pledge ofshares) and the rating resides mostly on strongcoverage, and solid performance and demandcharacteristics. Total DSCR (including notionalamortization of principal) is estimated to be 1.4xin 2009 and 2010. Debt amortizes in 2039 for a99-year concession.


Class Rating* Amount Interest** Legal final(mil.) maturity

G1¶ AAA§, (SPUR BBB) £300 Formula that accounts for relevant June 30, 2042index-linked UKTi and interest rate of 3.487%

G2¶ AAA§, (SPUR BBB) £150 Formula that accounts for relevant June 30, 2042index-linked UKTi and 3.487%

G3¶ AAA§, (SPUR BBB) £300 Formula that accounts for relevant June 30, 2042 index-linked UKTi and 3.487%

G4 AAA§, (SPUR BBB) € 73 Formula that accounts for relevant June 30, 2041index-linked OATi and 3.377%



A1 BBB £400 6.341% June 30, 2046

A2 BBB € 645 5.892% June 30, 204

A3 BBB £350 Six-month LIBOR plus 1.25% June 30, 2050

A4 BBB € 953 Six-month EURIBOR plus 1.25% June 30, 2050

Sterling liquidity notes A- £175 Six-month LIBOR plus 0.60% Dec. 30, 2050

Euro liquidity notes A- € 160 Six-month EURIBOR plus 0.60% Dec. 30, 2050

R NR*Standard & Poor’s ratings address timely interest and ultimate principal on the notes.¶The margin is 3.47% until June 30, 2009 and 2.887% thereafter.§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 theclass G2 and G5 notes, and Financial Security Assurance (U.K.) Ltd. for the class G3 and G6 notes.**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 beingfully subordinated to the payments on all the classes of notes and not rated.NR--Not rated.

Ratings Detail

Institution/role Ratings

Deutsche Bank AG as issuer bank account AA/Stable/A-1+provider and hedging provider

Goldman Sachs Group Inc. as hedging provider AA-/Stable/A-1+

AMBAC Assurance U.K. Ltd. AAA/Stable/--

FGIC UK Ltd. AAA/Stable/--

Financial Security Assurance (U.K.) Ltd. AAA/Stable/--

Supporting Ratings


Strengths, Concerns, And Mitigating Factors


Strengths:■ The business risk profile is considered “Satisfactory To Strong” (equating to a high ‘BBB’ to low

‘A’ category) based on long concession, high profitability, and strong free cash flow generation.

■ The management has a proven track record, with the successful implementation of significant cost reductions and revenue-enhancing strategy based on market segmentation.

■ Eurotunnel has the exclusive concession to operate the only fixed transportation link between the U.K. and France, which runs for another 80 years until 2086.

■ Strong operating margins: EBITDA margin for Eurotunnel has consistently been over 50% since 1999.

■ There are limited capital expenditure requirements resulting in positive free cash flow.

Concerns:■ The transaction is highly leveraged. The £2.9 billion of novated debt represents about 10.5x

2007 forecast EBITDA, increasing to £3.0 billion or 11x forecast EBITDA in 2013 due to debt accretion.

■ The amortization holiday may enable distribution to shareholders in the initial years, subject to a dividend lock-up trigger.

■ The transaction has a back-ended amortization profile with final maturity in 2050.

■ There is uncertainty regarding future competitive position over the medium to long term, due to unpredictable behavior of competing transport modes between the U.K. and France.

■ There is exposure to demand risk from core shuttle services and, to some extent, railway services, although the latter benefit from some government backing through guaranteed access charges.

■ As there is no currency hedge, there might be a mismatch between funds available in euro/sterling and the amount paid in the respective currency.

■ The ratings do not rely on enforcement of security, as the survivability of the issuer’s right of substitution post-insolvency, and the practical implementation of this right, have never been tested.

Mitigating factors:■ The transaction’s high leverage is sustainable and should be considered in view of Eurotunnel’s

long concession and strong business position, and of a mortgage-style amortization profile to alleviate refinance risk.

■ The total senior debt will fully amortize by 2050, two years ahead of the RUC term.

■ A payment test based on the synthetic debt-service coverage restricts distributions.

■ The substitution right, coupled with the security package (which includes the right for the security trustee to appoint an administrative receiver in England), and provisions ensuring that the issuer retains a blocking stake in creditors’ committees, should put the issuer in a favorable position in restructuring negotiations.

■ The debt breakdown between British pound sterling- and euro-denominated loans aims to replicate the revenue breakdown from the U.K. (in British pounds sterling) and from the continent (in euros).


Transaction BackgroundIn November 2006, Eurotunnel’s junior- andsenior-secured bank debt holders and tradecreditors approved a restructuring proposal toreduce the company’s debt from £6.20 billion to£2.84 billion. The plan was put forward underthe French “procédure de sauvegarde” granted onAug. 2, 2006, by the Paris commercial court, toEurotunnel and 17 related entities. This wasfollowed by the approval of bondholders on Dec.14, 2006, the approval of the Paris commercialcourt in January 2007, and a successful shareexchange in May 2007.

Standard & Poor’s considers the proposed newfinancial structure as offering a credible base forfuture operations and a sustainable leverage.

The Concession AgreementThe Concession Agreement (CA) was signed onMarch 14, 1986 by the states and theconcessionaires, under the Treaty of Canterbury.The CA expires in 2086. Initially entered into fora period of 55 years, the CA was extended by 10years and then 34 years in 1994 and 1999.

Under the terms of the CA, the concessionaireshave the right and the obligation, jointly andseverally, to design, finance, construct, andoperate Eurotunnel (the “Fixed Link”), and to doso at their own risk, without any governmentfunds or state guarantees.

Tariffs and commercial policy The concessionaires are free to set their tariffs.However, they must not discriminate betweenusers, notably with regard to their nationality ordirection of travel.

Penalties Any failure by the concessionaires to performtheir obligations under the CA entitles the statesto impose penalties after a grace period.

Early termination of the CA and compensation Each of the states may terminate the CA in theevent of a fault committed by the concessionairesif, within six months, the concessionaires havenot remedied the relevant breach, and subject togiving prior notice to the lenders of their right ofsubstitution. The CA defines a fault as a breachof a particularly serious nature of theconcessionaires’ obligations under the CA, orceasing to operate the Fixed Link.

Each of the states may terminate the concessionfor reasons of national defense. In this case, theconcessionaires may claim a compensationgoverned by the law of the relevant state. Eachparty to the CA may request the arbitrationtribunal, established under the Treaty ofCanterbury, to declare the termination of the CAin exceptional circumstances, such as war,invasion, nuclear explosion, or natural disaster. In

Transaction Participants

Borrowers The Channel Tunnel Group Ltd. (sterling tranches) and France Manche S.A. (euro tranches)

Original lenders Deutsche Bank AG and Goldman Sachs International Bank

Lead managers Deutsche Bank AG and Goldman Sachs International

Substituted entities Sub CLEF Ltd. (the English substituted entity) and Sub CLEF S.A.S. (the French substituted entity)

Issuer cash manager and issuer account provider The London branch of Deutsche Bank AG

Security agent, note trustee, and issuer security trustee Deutsche Trustee Co. Ltd.

Facility agent The London branch of Deutsche Bank AG

Security trustee Deutsche Trustee Co. Ltd.

Principal paying agent and agent bank The London branch of Deutsche Bank AG

Borrowers’ hedge counterparties The London branch of Deutsche Bank AG and Goldman Sachs International

Total return swap counterparties Deutsche Bank AG, London Branch and Goldman Sachs International

Total return swap custodian Deutsche Bank Aktiengesellschaft

Issuer corporate services provider Wilmington Trust SP Services (London) Ltd.

Monoline providers AMBAC Assurance U.K. Ltd., FGIC UK Ltd. and Financial Security Assurance (U.K.) Ltd.

Transaction Participants




such cases, in principle, no compensation is owedto the concessionaires. However, the states maypay the concessionaires an amount representingthe financial benefits, if any, that they may derivefrom the termination.

Any termination of the CA by the states, otherthan in a situation described above, gives theconcessionaires the right to payment ofcompensation. This compensation is for the entiredirect and certain loss actually suffered by theconcessionaires and attributable to the states,within reasonably estimated limits at the date ofthe termination, including damage suffered andoperating losses.

SubstitutionArticle 32 of the CA provides the lenders withstep-in or substitution rights to allow the transferof the concession and the assets required tooperate the concession to two entities owned bythe issuer. Step-in rights are triggered by certainpredefined events including a payment defaultunder the loan, an insolvency-related eventregarding the concessionaires, or if it appearsfrom an objective test that the estimated finalmaturity date for repayment of lenders will bematerially extended.

The U.K. and French governments, through aseries of government letters, have confirmed thatthe issuer is a “lender” for the purpose ofsubstitution, and that the rights to operate thefixed link will be transferred to one French andone English substitution entity.

This right of substitution would in any case besubject to French and U.K. governmentconfirmation that the substituted entities have the technical and financial capabilities toundertake substitution--a process that can take upto two months.

In addition, under the provisions of inter-creditor arrangements, the issuer (and hence thenoteholders) always maintains at least 51% of thevote in any creditors’ committee, allowing thecreditors to retain control of any futureinsolvency/restructuring process. This ensures theability to effect its step-in rights.

Transaction CharacteristicsThe debt restructuring details The proposed Eurotunnel refinancing plan isstructured around the existing concessionairesentering into a new long-term senior loan of

£2.84 billion, and the incorporation andformation of a new French holding companywhich, through an exchange tender offer, holds atleast 93% of the current Eurotunnel group. Theproceeds from the debt restructuring, as approvedby the safeguard procedure, were used to repayEurotunnel’s senior debt, Tier 1A, Tier 1, and Tier2 in cash at 100% of par including accruedinterests (£892 million); to finance a cashpayment to the holders of Tier 3 junior debtfacilities; and to pay certain fees, costs andexpenses related to the debt restructuring,including any interest accrued on existingEurotunnel facilities.

A subsidiary of Groupe Eurotunnel S.A. issued£1,275 million of notes redeemable in GroupeEurotunnel S.A.’s shares (NRS) that were offeredto the Tier 3 debt holders in exchange for theirexisting £1.78 billion of lendings, and to thebondholders in exchange for their part of thedebt. NRS were issued in addition to a cashelement paid to both parties. NRS convert into upto 87% of the common equity over three years;they are structurally and contractuallysubordinated to the senior debt. The dilution maybe lessened, however, by the exercise of warrantsissued to existing shareholders and bondholders,and the company’s ability, depending on its futureoperating performance, to repurchase the hybridnotes at a premium through proceeds from rightsissues, or through the issuance of an additional

Chart 1Channel Link Enterprises Finance PLC

Debt Restructure Summary


Termination events under the swap agreementsare limited to failure to pay, an event of defaultand acceleration of the notes, insolvency, illegality,and tax events.

There is no foreign-currency hedge, as the debtbreakdown between British pound sterling- andeuro-denominated loans aims to replicate therevenue breakdown from the U.K. (in Britishpounds sterling) and from the continent (ineuros). This creates foreign-currency risk if therevenue breakdown diverges from the loans’currency split.

Borrower call option agreementThe issuer entered into a borrower call optionagreement with the borrower hedgecounterparties. Under this agreement, the issuerhas an option to purchase a defaulting receivablefor sums due but unpaid by the borrowers undertheir hedge agreements. The purpose is to allowthe issuer to keep the borrower hedges currentand therefore to avoid a termination of theborrowers’ swaps.

The working capital facilityThere is a provision for a € 75 million workingcapital facility. The working capital facility rankspari passu to the securitized loan.

Additional debtObligors under the permanent facility, includingthe borrowers and Eurotunnel Group, can incuradditional secured indebtedness from a thirdparty in connection with certain definedcircumstances, including: (a) any refinancing of allor part of the existing facility; (b) a workingcapital facility up to € 75 million; and (c) any tapissues or new issues, subject to compliance withrating and financial tests. The obligors can alsoincur unsecured financial indebtedness subject tocertain caps, rating, and/or financial testing.

The intercreditor agreement limits the obligors’ability to incur new secured or unsecuredindebtedness. If the principal amount outstandingunder the permanent facility is lower than 51% ofthe aggregate principal amount of all financialindebtedness of the group, no member of thegroup can incur any additional debt unless thefacility agent, on behalf of the lenders under theterm loan agreement, is granted rights to control51% of the vote.

Loan CharacteristicsTable 1 summarizes the structure of the facilityand details the different tranches. The tranchesare all pari passu obligations of the borrowers.

Interest on the loanThe rate of interest on the loan is the aggregate ofthe following rate:

• From the issue date of the notes, a cash margin of 1.39%;

• A rate equal to 2.097% for tranche A1;• A rate equal to 2.587% for tranche A2;• A rate equal to 5.241% for tranche B1;• A rate equal to 4.792% for tranche B2;• A rate equal to six-month LIBOR plus 2%

from June 20, 2012 for tranche C1;• A rate equal to six-month EURIBOR plus

2% from June 20, 2012 for tranche C2; and• Mandatory cost.

Redemption profileThe loans are payable according to a schedule,and payments start as follows:

• Tranches A1 and A2 are paid in installmentsstarting on June 20, 2018, and ending on June 20, 2042 and June 20, 2041 respectively;

• Tranches B1 and B2 are paid in installments starting on June 20, 2013, and ending on June 20, 2046 and June 20, 2041 respectively; and

• Tranches C1 and C2 are paid in installments starting on June 20, 2046 and June 20, 2041 respectively, and ending on June 20, 2050.


Tranche Amount Legal maturity

Inflation-linked loans

A1 £750.0 2042

A2 € 367.0 2041

Fixed-rate loans

B1 £400.0 2046

B2 € 367.0 2041

Floating-rate loans

C1 £350.0 2050

C2 € 953.0 2050

Table 1 - Description Of The Structure Of The Facility



back rolling last-twelve-month basis is at least 1.25x; and

• Certain prepayments, capitalization, or waiver do not give rise to a tax liability.

Synthetic DSCR is defined as the ratio of netcash flow (NCF) to the higher of debt service andsynthetic debt service. NCF is defined as EBITDA,minus capital expenditures and working capitalchange, plus any interest revenue received.Synthetic debt service is defined as net financecharges other than the step-up amount, thesynthetic amortization schedule of the loan, andany actual amortization profile of any debtobligation other than the loan. Syntheticamortization profile is modeled as if the loan waspaid down as an annuity.

Business ProfileBusiness descriptionEurotunnel operates the Channel Tunnel betweenthe U.K. (Folkestone) and France (Calais; see thesystem map in chart 5) under a concessiongranted by the U.K. and French governments until2086. The Dover-Calais/Dunkerque corridor (the“short straits”) is the shortest and most widelyused of all cross-channel routes.

Eurotunnel offers a service that it operates itselfbetween Calais and Folkestone, and which

competes directly with ferry operators in thetransport of passengers, cars, coaches, and trucksin specially designed railway carriages(Eurotunnel’s own shuttle services generated 56%of € 830 million turnover in 2006).

It also offers an infrastructure facilitating adirect rail link for the Eurostar trains and freight trains; 50% of tunnel capacity is made availableto the British Railways Board (BRB; a U.K.government agency) and Société Nationale desChemins de Fer Français (SNCF; the French state-owned railway operator). Railway revenues represented 42% of turnover in 2006.

The tunnel is directly linked to the British andFrench motorway and railway networks. All railtraffic in the tunnel is controlled from railwaycontrol centers on the French and Britishterminals.

The system comprises three tunnels. Two of thetunnels are single-track rail tunnels, which innormal service are used by trains traveling in onedirection only. The third tunnel provides a safemeans of emergency evacuation and access formaintenance of the tunnel. There are also four crossing points between the rail tunnels, so thatwhen maintenance work is being done on asection of one tunnel, trains can switch to the other.

Chart 5The Eurotunnel System


Profitability: large portion of operating costsfixed in natureStandard & Poor’s forecasts the EBITDA marginto remain high and above 50% in the comingyears. The yield management strategy, throughhigher load factors and efficient pricing policy, isexpected to keep the operating margin high, withmore revenue and yield stability than in the past.In addition, the DARE plan has resulted in alower break-even level, meaning the company isin a better position to withstand any futureeconomic downturn or increased competition.As summarized in table 2, the combined effects ofhigher revenues (up 4.7%) and well-controlledoperating expenses (up 3.8%) led to an 11.9%increase in EBITDA, to €490 million in 2006. TheEBITDA margin reached a record 59% ofrevenues in 2006, up from 55% in 2005 and 53%in 2004.

On the operating expenses side, the mainincreases in energy costs (up 25%), maintenancecosts (up 6%), and local taxes (up 7%), werepartially offset by reductions in the cost ofconsumables (down 11%), in consultants’ fees(down 10%), and in employee benefit expenses(down 15%).

Total revenues for Eurotunnel during the firsthalf of 2007 reached £252 million, 8% downfrom the previous comparable period. Excludingthe effect of the loss of the MUC, revenues have

increased by 7% on trucks, Eurostar and cartraffic growth; operating costs have decreased 2%and EBITDA at 56% of revenues rose 15%. Ifthis trend is maintained for the year, 2007revenues will exceed forecasts, resulting in higher-than-expected DSCR. The second half of the yearwill however include a proportion of the £88million restructuring costs.

Outlook by revenue segmentTruck shuttles. The growth rates in Eurotunnel volume until2009 are expected to be in line with GDP,reflecting the company’s yield focus. In the longerterm (post-2009), Standard & Poor’s estimatesthat Eurotunnel’s market share will stabilize,growing by an average rate of approximately 1%to 2% per year.

The company’s truck shuttle strategy is to givepriority and cheaper prices to regular customers,who in return agree to forecast daily volumes.This policy, together with the regained control ofdistribution channels, has enabled Eurotunnel tomatch capacity with demand. As a result, loadfactors on the truck shuttle services haveincreased to 71% in 2006 from 59% in 2004;and revenue increased by 7% in 2006 over 2005,due to the increase in average prices. The first halfof 2007 maintains strong momentum, withvolumes up 9%, and overall shuttle revenues up


(Mil. € ) 2006/2005 2005/2004

Income statement (Mil. € ) Dec. 31, Dec. 31 Dec. 31, Change Change2006 2005 2004

Exchange rate (€ /£) 1.462 1.465 1.466

Revenue 830 793 789 37 4

Operating expenses 219 211 213 7 (2)

Employee benefit expenses 122 143 154 (22) (11)

Operating income 490 438 421 51 17

Depreciation 164 208 228 (45) (19)

Current operating income 326 230 193 96 37

Impairment of property, plant and equipment 2,490 475 (2,490) 2,016

Other operating income (expenses) 7 (41) (68) 48 28

Operating profit (loss) 333 (2,301) (350) 2,634 (1,951)

Income from cash and cash equivalents 5 8 8 (2) 0

Cost of servicing debt (gross) 492 497 501 (5) (3)

Net cost of financing and debt service (487) (490) (493) 3 3

Other financial income (charges) (50) (18) 6 (32) (24)

Income tax expense 0 0 0 0 0

Profit (loss) for the year (204) (2,808) (836) 2,604 (1,972)

Table 2 - Eurotunnel Financial Summary



8%, on the previous comparable period.Further downside risk cannot be excluded,

however, and overall yields may come undersignificant pressure as ferry companiesaggressively and increasingly compete for market share.

The new approach has also yielded bettervisibility in terms of traffic forecasting, as somemajor customers have entered into multi-yearcontracts with Eurotunnel. These contracts enablecustomers to lock in their requirements in termsof number of crossings, and enable Eurotunnel tofine-tune its capacity planning. Furtherrefinements of this approach are planned for 2007.

Car shuttles.Standard & Poor’s considers that this segmentwill be relatively stable in the future.

Eurotunnel’s share of the passenger car marketon the short straits link has reduced to 43.5% in2006 from 45.5% in 2004. This was largely dueto SpeedFerries’ entry into the market in May2005, to the gradual increase in Norfolkline’spassenger capacity in 2005 and 2006, and to theimpact of Eurotunnel’s new commercial strategy.

The new Eurotunnel strategy implementedduring 2005 has focused on improving yieldsthrough dynamic ticket pricing after taking intoaccount the load factor and time of arrival,changing the customer mix in favor of the non-daytrip passengers versus the daytrip passengers,and implementing a 34% reduction in capacity,with less availability for daytrip passengers.

With this strategy, Eurotunnel has been able toincrease the load factor on its passenger shuttlesto 62.5% in 2006 from 45.1% in 2004, and carrevenues by 10% (due to the 11% increase in theaverage yield). The first half of 2007 maintainsstrong momentum, with volumes up 8% on theprevious comparable period.

Coach shuttles.The coach market, which has declined by around4% per year between 1998 and 2006, is expectedto remain a marginal contributor to revenues. Thecontinuing decline is due to factors such as theloss of duty-free, and increased competition fromairlines for leisure and price-sensitive non-leisuretrips. Further decline cannot be excluded in thisprice-sensitive market.

Eurotunnel’s share of the passenger coach

market on the short straits link has risen to38.9% in 2006 from 33.5% in 2004.

Coach revenues were down 11%, mainly due tolower volumes, which decreased by 13% in 2006and returned to a level comparable to that of2004. Average yields increased by a modest 2%.Volumes decreased by another 2% in the first halfof 2007 on the previous comparable period.

Railways.Railway revenues (including MUC payments)increased by 2% to €350 million in 2006.Excluding the MUC, the underlying increase inrailway revenues was 7% in 2006, due in part tothe 5% increase in Eurostar passenger traffictraveling through the tunnel.

In 2007, railway revenues are not protected bythe MUC, and are forecasted to fall byapproximately 25% (the actual figure was 27% inthe first half of 2007).

Passenger rail (Eurostar).Standard & Poor’s expects Eurostar’s long-termgrowth to be in line with GDP, with a marketshare stabilized a couple of years after CTRL2(Channel Tunnel Rail Link-2).

Eurostar has shown impressive passengergrowth since 1997 except between 2000 and2003, primarily due to low-cost airlines drawingpassengers to other destinations. The companyhas however fallen short of expected volumes,which were overly optimistic. Further materialgrowth is not expected before November 2007,when Eurostar’s competitive position shouldbenefit from the second phase of the U.K. high-speed link CTRL2 (reducing inter-capital journeytime by an additional 20 minutes, and theopening of two additional stations, increasing thecatchment area). Thereafter, extension ofEurostar’s rail links to Amsterdam couldpotentially add some volume.

Growth in Eurostar traffic, which had beenrestrained by the July 2005 terrorist attacks inLondon, resumed in 2006. Paris to Londonpassenger numbers were up by 4.2% in 2006, at5.66 million (and by 4.8% over the first sixmonths of 2007, at 3.90 million). In 2006,Eurostar had 70.2% of the Paris to Londonpassenger market. On the Brussels to Londonpassenger market, the 2006 figures were 2.2million (up 8.5%) and 71.7% respectively.Eurostar, whose first-half sales were up 13.6% on

the previous year, announced that it will increasethe number of weekday trains it runs betweenParis and London in February 2008, to 17 from15. This is positive for Eurotunnel.

Rail freight.Stability of freight revenues in the short-to-medium term is a best-case scenario, while afurther reduction is a more likely outcome.

Future revenues are uncertain after the end ofthe subsidy to EWS in 2006, while the service hasrelied on state subsidy since services commencedin 1996. Also, the impact of the purchase of EWSby Deutsche Bahn AG (AA/Negative/A-1+) fromBRB remains to be seen.

Eurotunnel considers a possible upside,however. Eurotunnel intends to revive use of thetunnel by revising the fee structure for rail freight,making it cheaper for freight trains to run atnight, while charging more at the busiest periodssuch as Friday evenings and Monday mornings.The move could be related to Eurotunnel’sintention to directly operate some cross-channelrail freight services (it has an operating licensewith its Europorte2 subsidiary). The group haspurchased locomotives in the first half of 2007and has also ordered some additional locomotivesto Bombardier to be used in the development ofits rail freight activity.

Rail freight services have tended to fare lesswell than other Eurotunnel markets. Perhaps themost important episode was the severe disruptionassociated with asylum seekers using trains toattempt to travel to the U.K. in 2001. This has ledto freight users pulling out in favor of othertransport alternatives, and the market has neverreally recovered.

The volume of goods transported by freighttrains declined by 1% compared with 2005, to1.57 million tons, after a 16% decline in 2005. In1998, 3 million tons of freight moved through thetunnel, which is designed to carry a maximum of10 million tons. In the first half of 2007, trafficvolumes were 14% down on the previouscomparable period.

CompetitionEurotunnel is the operator of an essentialinfrastructure, but its revenue streams are not aspredictable as for toll road network, airport, orport operators, which benefit from the

monopolistic nature of their industries. The future strategy of competitors (such as

ferry companies and airlines) remains difficult topredict, meaning GDP or market growth does notalways materialize in volume or revenue growth.Since 1996 (1997 for Eurostar services), truck andrail passenger volumes have increased, whereascar, coach, and rail freight volumes have tendedto fall.

The primary competition risks in the passengermarket are low-cost and flag airlines and, to alesser extent, ferry operators. The shuttle serviceenjoys a competitive advantage in terms of speed,frequency of departures, and reliability, which isreflected in its premium pricing. A significantcompetition risk stems from the ferry operatorsP&O, SeaFrance, Norfolkline, and SpeedFerries.Standard & Poor’s considers the impact onEurotunnel’s truck shuttle revenues to be limitedas a result of the successful segmentation strategy;the expected impact on car and coach shuttlerevenues could be higher, and was factored in thebase case. Eurotunnel estimates that its share ofthe accompanied truck market on the short straitscorridor decreased to 36.2% in 2006 from 39.5%in 2005, reflecting its new strategy.

Finally, freight trains compete directly withroad transport and maritime transport oncontainer ships. Intense competition in the cross-channel freight market between road haulagecompanies has recently put downward pressureon freight rates, making it more difficult for therailways to compete. The goods transported byfreight trains are mainly heavy, lower-yieldingitems for which speed of delivery is not generallya primary consideration.

Capital expenditure and maintenanceScheduled weekly maintenance of the tunnel isorganized and structured to minimize disruptionto commercial operations and optimize capacityduring peak periods.

The second cycle of rail replacement began in2005, and will continue until 2008 withoutdisrupting commercial services. Under currentrolling stock maintenance programs, essentialmaintenance and safety inspections are carriedout on average every 21 days for the locomotives,freight shuttles, and passenger shuttles. The large-scale maintenance program that began in 2003 isaccelerating considerably in 2007, to restore and



enhance the reliability of equipment that is nowapproaching one-third or one-half of its overalluseful service life.

At present, the tunnel’s capacity does notconstrain the development of the different typesof traffic. In the medium or long term, capacitycould be improved by restricting access to slowfreight trains at peak times, and by schedulingtrains so that they run in batteries.

Medium-term capital expenditures are expectedto remain at about £30 million to £40 million peryear, and are related to maintenance and upgradeprograms. An increase in the existing shuttle fleetdoes not form part of Eurotunnel’s currentstrategy. Eurotunnel aims to take electric powerfor the entire tunnel from the French nationalgrid, which distributes lower-priced energy thanthe British grid; this requires limited investment tohelp better control unhedged electricity costs.

At the end of July 2006, Eurotunnel and therailways entered into an agreement, bringing anend to a dispute that began in 2001 over thecalculation of the railways’ contribution to thetunnel’s operating costs. This confirmed thedecisions made for the financial years before2004, set out the agreement for 2005, and set thecontributions on a fixed-payment basis for the

financial years 2006 to 2014 inclusive. Aconsultation process was also established todetermine the railway operators’ contributions tothe renewal, and the related replacement costs.

Insurance coverageEurotunnel’s insurance program primarilycomprises policies covering materialdamage/business interruption (including terrorismrisk) and third-party liability. The materialdamage/business interruption policy covers for anamount corresponding to the “maximum possibleloss”. The indemnification period for businessinterruption is 24 months from the start of the interruption.

The most notable incident was a major fire in1996, which interrupted the business for severalmonths, but was covered by the insurance.

The Railways Usage Contract (RUC) The railways’ use of the tunnel is governed by theRUC, which runs until 2052. Under thisagreement, the railways must pay Eurotunnel afixed annual charge, and variable chargesdetermined by reference to the number ofpassengers traveling on Eurostar and the freighttonnage passing through the tunnel. The variablecharges are determined according to a tollformula that takes into account inflation to acertain extent and makes adjustments whenspecified volume thresholds are exceeded. Anychange to the RUC requires the lenders’ approval.

Until the end of November 2006, the railwayshad to make additional monthly payments tobring Eurotunnel’s annual revenue up to theguaranteed minimum usage charge (MUC). In 2006, Eurotunnel received a total of €350 million in payments: €255 million invariable charges, fixed annual charges, andcontributions to operating costs, and €95 millionrelating to the MUC.

Note Terms And ConditionsInterestInterest is paid semiannually on payment datesfalling on June 28 and Dec. 28 of each year.However, the note interest accrual dates are therelevant loan interest payment dates, being June20 and Dec. 20 of each year. The eight-daydifference between the payment dates under theloans and the payment dates under the notes was



Notes Interest

Class G1* Formula that accounts for relevant index-linked UKTi and interest rate of 3.487%



Class G4 Formula that accounts for relevant index-linked OATi and interest rate of 3.377%



Class A1 6.341%

Class A2 6.341%

Class A3 Six-month LIBOR plus 1.25%

Class A4 Six-month EURIBOR plus 1.25%*The margin is 3.470% until June 30, 2009 and 2.887% thereafter.

Table 3 - Interest By Class Of Notes

included to allow the issuer to make a drawdownunder the liquidity notes in the event of ashortfall, and to enable the trustee to serve anotice of demand under the financial guaranteesin the event of a payment default under the loans.The interest paid by each class of notes issummarized in table 3 on the previous page.

Redemption Profile If the issuer receives any unscheduled prepaymentamount from the borrowers, it prepays the debtoutstanding on a pari passu basis with thefollowing priority:

• Any amounts due and payable on the X certificates;

• Any principal redemption amounts on the prepayment due on the corresponding tranches of the notes; and

• Any make-whole prepayment to the corresponding tranche of notes.

On a mandatory prepayment, the issuer prepaysthe notes pro rata, except where the prepaymentrelates to refinancing of all or any tranche of thepermanent facility, in which case the proceeds areapplied by the issuer to redeem the correspondingtranches of notes pro rata.

Each class of notes can be paid in whole or inpart, subject to certain prepayment penalties, andin a minimum amount of £5.0 million or € 7.5 million.

On a substitution event of the existingconcessionaires and the acceleration of thepermanent facility, the issuer sweeps cash receivedto redeem the notes, unless it can invest in eligible investments that replicate the payment on the notes.

Early redemption and the authorized investment(AI) OptionUnder condition 10(h), the monolines hold anoption that can be exercised upon a full or partialprepayment of the tranche A loan (thatcorresponds to class G notes at the issuer level) incase the proceeds from prepayment of the loanare not sufficient to pay the relevant noteredemption amount plus the net present value ofthe financial guarantee fee, provided no loanevent of default has occurred. This option allowsthe monoline to invest the amount prepaid (whichnormally would have been applied in redemptionof the tranche G notes) in a defeasance account tobe invested in authorized investments. Such

investments need to produce amounts at leastequal to amounts payable in respect of the notes(including the guarantee fee) on each scheduledpayment date in respect of this principal amountand in respect of the relevant proportion of thetranche A loan prepaid.

Practically, if the monolines exercise this option,they have to make sure that a defeasance accountis opened with the issuer bank account providerin the name of the issuer--one for each class of Gnotes that would have been prepaid if the optionwere not exercised. In addition, a custodian isappointed with regard to defeasance accounts tohold the monoline authorized investments on theissuer’s behalf.

The cash standing on these accounts togetherwith the proceeds generated by the monolineauthorized investments is taken into account inthe waterfall for the payment of interest andprincipal of the relevant class G notes. This isbecause the loan has been prepaid and thereforeno further interest or principal is paid by theborrower on that portion of the loan.

If the tranche A1 or A2 loan has been prepaidin full and the authorized investment (AI) optionhas been exercised by the monolines, the trusteenotifies the tranche G noteholders. Once thenoteholders have been notified, within 30 days,they can ask to redeem the tranche G notes that they hold to the extent that the notes would have been redeemed had the prepaymentnot been the subject of the AI option. The amountreceived by the relevant tranche G noteholderfollows the payment of amounts due to therelevant monoline.

Issuers’ pre-enforcement priority of paymentsBefore enforcement, the issuer applies theavailable funds plus any liquidity drawings, savethat (i) if the monoline has exercised the AIoption, any AI receipts generated from a certaindefeasance account are used only to pay therelevant monoline or the relevant class Gnoteholder for which that account has beenopened, and (ii) if the noteholders have exercised their AI option, the amounts received inthe relevant defeasance account are used only torepay the relevant monoline, in the following order:

• Senior expenses related to the transaction, including trustee fees, rating services fees, and corporate servicer fees, total return



swap custodian, plus any moneys to be paid into the issuer’s expenses reserve accounts and any amounts to be credited to the liquidity accounts up to the required liquidity amount;

• Any interests due on the liquidity notes;• Any principal due on the liquidity notes;• Any amount due to the TRS counterparties;• Any amount due to the borrower hedge

counterparties;• Pro rata and pari passu, according to the

respective amounts;• Any interest due or accrued, any principal,

any amount in excess of the par amount (always excluding step-up fees) on the tranche A notes, and any counterparty fixed-rate note payment under the margin basis swap. All such amounts are applied pro rata and pari passu to all tranche A notes, but within each tranche applied according to thefollowing order:

♦ Interest due and accrued;♦ Principal due; and♦ The amount in excess of the par amount

upon early redemption and any counterparty fixed-rate note payment under the margin basis swap.

• For each class G note depending on the monoline, the aggregate of: (i) guarantee feesand other amounts then due to the relevant

monoline, taking into account any AI receipt for that amount; (ii) all amounts of interest due or taking into account any AI receipt for that amount; (iii) any principal taking into account any AI receipt for that amount; and (iv) any amounts in excess of the indexed par amount payable on early redemption due and payable on the relevant tranche G notes, taking into account any AI receipt for that amount. This amount is applied pro rata and pari passu for the relevant tranche G notes, but in the following order of priority:

♦ Guarantee fees and other amounts due to the relevant monoline;

♦ Interest due and accrued on the relevant tranche G note;

♦ Any amounts to be reimbursed to the relevant monoline with regard to any interest paid under the guarantee;

♦ Scheduled principal due on the relevant tranche G note;

♦ Any amounts to be reimbursed to the relevant monoline with regard to any scheduled principal paid under the guarantee;

♦ Any amounts to be reimbursed to the relevant monoline with regard to any unscheduled principal paid under the guarantee;

♦ Any amount of unscheduled principal due to the relevant tranche G notes; and

♦ Any amount in excess of the par amount upon early redemption on the relevant tranche G note.

• Step-up amounts on the class A3 and class A4 notes;

• Additional amounts including withholding tax gross-up;

• Any subordinated amounts to the hedge counterparties; and

• The amount in the issuer’s transaction account to the holder of the class R certificates, once all the amounts on the notes listed above have been paid in full.

The issuer’s post-enforcement waterfall is thesame as the issuer’s pre-enforcement priority ofpayments, except for additional payments to thetrustee on enforcement.

Notes’ events of defaultThe issuer’s events of default are limited to:

• Nonpayment under the notes;• Failure to comply with the transaction

documents;• Misrepresentation; and • Insolvency.

Controlling creditorsThe controlling creditors are the monolines for aslong as the wrapped tranches G1, G2, G3, andG4 are outstanding, or any payment due to themonolines is still outstanding. Once the tranche Gnotes have been redeemed in full and no furtherpayments are due to the monolines, the trancheA1 and A2 notes become the controlling creditors.When the tranche A1 and A2 notes have beenfully redeemed, the control passes to the trancheA3 and A4 noteholders. Once all the tranche Gand A notes are redeemed, the trustee acts onbehalf of the liquidity noteholders.




Credit And Cash Flow EvaluationStandard & Poor’s analysis focused on a stressedbusiness plan and EBITDA levels from themanagement’s base case. The company’s case thatwas used for the debt restructuring waselaborated in 2005 on reasonable assumptions.

Standard & Poor’s implemented a 20% haircutto the net present value (NPV) of the company’snet cash flow (NCF) (equivalent to 23% of thesum of revenues) on the life of the transaction. Inthis case, the business grows on average by anominal 2.2% per year. Bearing in mind thatEurotunnel’s management case is alreadyoperating at a fairly low level, Standard & Poor’sestimates that the level of stress implemented iscommensurate with a ‘BBB’ rating.

Eurotunnel’s significant tax loss carry-forwardallows all the pre-tax cash flow to be used for

debt service in the first 10 years or so.NCF is used for the DSCR calculation. At the

borrower level, under the management base case,the minimal scheduled NCF DSCR is at 1.48x(first year); it then improves, reflecting theexpected volumes and cash flow growth. UnderStandard & Poor’s stressed case, the ratio reachesa minimum of 1.36x in year six when principalamortization kicks off. This is a low butacceptable ratio for a concession with volume risk. That is above the 1.1x event ofdefault covenant.

The results from the cash flow analysis areshown in table 4.

As a result of Standard & Poor’s cash flowanalysis, £2.9 million (or 10.5x forecast EBITDA)is considered commensurate with a ‘BBB’ rating.Given the hybrid nature of the business, the


June 30, June 30, June 30, June 30, June 30, June 30, June 30, June 30, June 30, June 30,2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

NCF DSCR (scheduled)

Management case (x) 1.48 1.54 1.62 1.67 1.75 1.59 1.63 1.73 1.90 2.05

Standard & Poor’s case (x) 1.47 1.44 1.46 1.49 1.53 1.36 1.40 1.44 1.48 1.53

Debt/(EBITDA-essential capex)



Synthetic DSCR (NCF/(Higher of actual and synthetic DS))



NCF ICR



(FFO + interest)/interest



FFO/Net debt

Management case (%) 9.2 9.4 10.0 10.4 10.4 10.8 11.3 11.9 12.5 13.3

Standard & Poor’s case (%) 9.1 8.9 8.8 8.9 9.0 9.2 9.5 9.8 10.1 10.4

Table 4 - Cash Flow Analysis Compared Outcomes Under Management And Standard & Poor’s Cases



length of the concession, and its bi-nationaleconomics, it is impossible to find a suitable peerto Eurotunnel.

Accounting Issues Since December 2005, Eurotunnel Group’sfinancial statements have been prepared inaccordance with IFRS.

Going concernThe auditors and Commissaires aux Compteshave reported on the 2006 accounts. Their reportcontained matters of emphasis relating to goingconcern, the valuation of property, plant, andequipment, the consequences of theimplementation of the safeguard plan on the accounts, and the nonapproval of the 2005 accounts.

Treatment of the accounts on a going concernbasis depends on the full implementation of thesafeguard plan, which seems increasingly likelynow that the exchange tender offer has beensuccessful, with 93% of the share capital finallytendered. Going concern involved, notably, thedrawing of the term loan (this has now beensuccessfully implemented), and the failure of anylegal action aimed at blocking the safeguard plan(all recourses seem to have been rejected). If all ofthe elements of the safeguard plan are not put intoplace, Eurotunnel’s ability to trade as a goingconcern would not be assured. The accountswould be subject to certain adjustments, whoseamounts cannot be measured at present. Theadjustments would relate to the impairment ofassets to their net realizable value, the recognitionof liabilities, and the classification of noncurrentassets and liabilities as current assets andliabilities. The asset value on liquidation has beenestimated at £890 million by the valuer/auctioneerappointed by the safeguard procedure.

Impairment of property, plant, and equipmentSince 2003, the group has applied IAS 36methodology, which requires the net book valueof assets to be compared with discounted futureoperating cash flows. The application of thisstandard at Dec. 31, 2005 gave rise to a value inuse £1.75 billion lower than the net book value ofthe assets, and led to an impairment charge forthis amount in the 2005 accounts. Impairmentcharges for £1.3 billion and £395.0 million werealready made in the 2003 and 2004 accounts.

The recognition of impairment charges at Dec31, 2005 caused Eurotunnel’s main companies tohave negative total equity. Under the safeguardplan, these companies’ equity was reconstitutedthrough debt capitalization after the tender offer.

In 2006, Eurotunnel did not make anyimpairment charge. The depreciation chargedecreased by 21% in 2006 following theimpairment charge in 2005.

Recovery Rating AnalysisStandard & Poor’s assigned a recovery rating of‘2’ to the €2.84 billion senior secured loans. Thisindicates Standard & Poor’s expectation ofsubstantial (70% to 90%) recovery of principal inthe event of a payment default.

ApproachFor the loan recovery estimate, Standard & Poor’scombined an NPV approach (akin to projectfinance transactions) with a debt multipleapproach (as for corporates), reflecting the hybridnature of Eurotunnel.

Standard & Poor’s used an enterprise valuationbased on going concern because it considers thatgreater value will remain in the business if it isreorganized rather than liquidated.

Based on the live example of Eurotunnel’s debtnegotiations and financial restructuring between2005 and 2007, Standard & Poor’s assumes thatan event of default at the borrower level would befollowed by a successful negotiation with thecreditors, leading to a consensual debtrestructuring instead of a substitution. The newdebt structure is becoming much simpler, favoringa consensual restructuring.

Payment default scenarioStandard & Poor’s simulated payment defaultassumes a severe traffic shock in 2013, leading toa borrower’s default at the time of the firstprincipal payment that year.

In 2013, the borrower’s total debt service willbe about £182 million; NCF needs to fall to £200million for an event of default on the term loan.Assuming £15 million of saving could be made oncapital and operating expenditures, the event ofdefault requires EBITDA to fall to approximately£225 million (a 20% fall under Standard & Poor’sscenario, which is already stressing themanagement’s case).

Following the event of default at the borrower’s

level, Standard & Poor’s assumes the issuer wouldhave to draw entirely on its debt-service reservefacility to meet its obligations on the notes.

Estimated recoveryUnder the NPV approach, Standard & Poor’sassumes EBITDA to remain constant at £230million per year in real terms (assuming an annual2% inflation) from 2015 until 2050 (with capexand WC assumptions unchanged). The LLCR(loan life cover ratio) at year 2015 is at about0.9x, calculated with a discount rate of 8%.

Standard & Poor’s focused more on LLCR thanon CLCR (concession life cover ratio); althoughthe concession matures in 2086 and there will becash flows beyond 2050, the visibility of cashflows more than 40 years from now is limited(especially as the RUC ends in 2052). In addition,with regard to the period between 2052 and2086, the concessionaires will be obliged to payto the states a total annual sum, including allcorporate taxes of any kind, equal to 59% of allpre-tax profits.

Under the debt multiple approach, Standard &Poor’s has estimated the recovery prospects based on:

• A similar distressed EBITDA base of about £230 million; and

• Average valuation multiples of 8x to 10x, representing a haircut with the current restructuring (10.5x to 11x), and more in line with some other infrastructure deals.

This would result in a recovery ranging fromabout 60% to 74%. ■




COPENHAGEN AIRPORTS A/S

RationaleThe rating on Copenhagen Airports A/S (CPH) issupported by the airport’s strong competitiveposition as a natural hub for Scandinaviancountries. The rating also reflects CPH’s efficientaviation and strong commercial operations, theadequate regulatory environment, strong cashflow generation, and sound financial flexibility.Offsetting these strengths are CPH’s relativelylarge proportion of transfer traffic and highcustomer concentration. The rating is alsoconstrained by the company’s weakened financialprofile following Macquarie Airports (MAp)’s(BBB/Stable/--) acquisition of a controlling stake inCPH in December 2005 through financing vehicleMacquarie Airports Copenhagen Holdings ApS(MACH; BBB+/Stable/--). As a result of thispartial acquisition we consolidate MACH’s debtwith CPH’s own Danish krone (DKK) 2.0 billiondebt (about €269 million), given the level ofMACH’s control and ownership. The acquisitiondebt is nonrecourse to CPH, however, leavingCPH’s pre-existing debt structure unaffected.

Copenhagen Airport handled 20.9 millionpassengers in 2006. In the first half of 2007,traffic increased by 2.3% year on year on the backof increased flight frequencies and new routes.CPH enjoys a strong competitive position,supported by its main carrier ScandinavianAirlines (SAS), which uses the airport as itsregional hub. Nevertheless, CPH’s proportion oftransfer traffic has been declining since 2003,albeit remaining high at about 30%, whichStandard & Poor’s Ratings Services considers aweakness. Moreover, the company derives abouthalf of its passenger volume from SAS and runsthe risk of losing part of its transfer traffic if SASceases to operate.

CPH achieved an EBITDA margin of 54.1% in2006--which is high compared with peers--owingto its efficient operations, strong cost manage-

ment, and successful commercial operations,which rank among the best in Europe.

At June 30 2007, gross debt at MACH andCPH combined declined to DKK7.1 billion, fromDKK8.9 billion at Dec. 31, 2006, as proceedsfrom a special dividend distribution from CPH’sassociated company Newcastle InternationalAirport Ltd. and from the sale of CPH’s Chineseand part of its Mexican operations were used fordebt repayment. At end-December 2006, fundsfrom operations (FFO) to average total debt andFFO interest coverage were 12.6% and 3.2x,respectively, and free cash flow generation wasDKK494.7 million, according to Standard &Poor’s calculations.

Liquidity CPH has strong liquidity. At June 30, 2007, thecompany had about DKK1.0 billion in unusedcommitted bank lines and DKK225.4 million incash. Debt maturing within the next five years isnot a concern, because maturities are manageableand we expect CPH to remain cash flow positiveafter dividend distributions. Liquidity is furthersupported by a modest and flexible capitalexpenditure program.

Outlook The stable outlook reflects our expectation thatCPH will maintain its strong competitive positionand focus on growth of internal cash flowgeneration. Free cash flow generation is expectedto continue, but is unlikely to result in significantearly debt repayments given our expectation thatthe company will use the cash for dividendpayments and capital spending. Any capital returnto shareholders will limit rating upside.

Major industry events causing a consistentpassenger volume decline or a significantdeterioration in SAS’ operations could pressure therating, as could a further increase in leverage. ■


Publication Date:

July 23, 2007

Issuer Credit Rating:BBB+/Stable/--

Primary Credit Analyst:Maria Lemos, CFA,London, (44) 20-7176-3749

Secondary Credit Analyst: Alexandre de Lestrange, Paris, (33) 1-4420-7316

RationaleThe ratings on Germany-based integrated railwayand logistics company Deutsche Bahn AG (DBAG) reflect the company’s strong business riskprofile derived from its dominant position andstrategic importance in the German transportsector, as well as the close relationship with, andsupport from, its current 100% owner, theFederal Republic of Germany (AAA/Stable/A-1+).DB AG’s strengths are offset by an intermediatefinancial risk profile and uncertainties related tothe expected privatization of up to 49% of thecompany’s capital.

Standard & Poor’s Ratings Services applies atop-down rating approach for government-supported companies, which notches down fromthe sovereign rating, as the credit standing islinked to that of the government. The ratings onDB AG, which are two notches lower than thoseon Germany, reflect the absence of direct stateguarantees for outstanding debt and thattimeliness of financial support for the company isnot explicitly guaranteed. Nevertheless, the statehas demonstrated its support for DB AG throughthe full backing of its acquisitions andinvestments in recent years, significant directgrants for network investments, and indirectpayments through the regional states for servicesprovided by DB AG and its subsidiaries. Ministryofficials have also repeatedly given clearstatements to Standard & Poor’s that the statewill continue to support DB AG in its currentform and ensure that it maintains a sustainablecredit profile.

DB AG continues to provide essential railwayservices within Germany, but its acquisitions,mainly in the logistics sector, have transformedthe company into a worldwide integrated mobilityand logistics firm that in 2006 derived about 50%of its revenues from non-railway services. Statesupport is therefore a key consideration for the‘AA’ rating, as Standard & Poor’s assesses thebusiness risk profile of the logistics industry asweaker than that of the railway business, and DBAG’s current stand-alone financial risk profile isnot in line with an ‘AA’ rating.

DB AG’s first-half 2007 results were in linewith Standard & Poor’s expectations and boostedby a strong performance across all business areas.DB AG’s financial debt decreased by about €600 million to €18.9 billion compared with theend of December 2006 and its EBIT improved by

about €400 million to €1.35 billion. Standard &Poor’s expects that DB AG’s key debt and interestcoverage ratios will improve further in 2007.Moreover, we expect that the company willcontinue to reduce leverage and improve itsfinancial risk profile over the medium term.

Short-term credit factorsDB AG’s liquidity remains strong, owing mainlyto its easy access to capital markets and acomfortable cash position of €992 million at theend of June 2007. In our view, DB AG should beable to refinance upcoming maturities owing to itsvery good access to the capital markets. Inaddition, the company has sound liquiditythrough committed bank facilities.

OutlookThe negative outlook reflects our concerns andquestions related to the expected partialprivatization that was approved by the Germangovernment on July 24, 2007. Areas ofuncertainty are DB AG’s ability to continuereducing leverage under a partial privatization,whether it could come under pressure to makedividend payments that are currently not part of its financial forecasts, and whether it would potentially adopt a more aggressiveacquisition strategy.

We will need to assess whether similargovernment support will and can be provided forthe privatized entity. The service and financingagreement currently being negotiated wouldsuggest consistent levels of financial commitmentfor extended time periods. We would also need toassess the company structure post privatization.An important factor will also be how much of theprivatization proceeds will be used to improve thecompany’s balance sheet.

After a minority privatization, we expect toswitch to a bottom-up rating approach, mostlikely still factoring in state support, but reflectingreduced government ownership in the business.We would also adopt this approach if DB AGmade additional large acquisitions in themeantime, similar to those of logistics companiesBAX Global and Stinnes AG, which wouldfurther expose DB AG to logistics activities. Thelatter could have negative rating implications, asthe business risk would increase because strategicrail and infrastructure services would become less relevant. ■


DEUTSCHE BAHN AG


Publication Date:

Sept. 19, 2007

Issuer Credit Rating:AA/Negative/A-1+

Primary Credit Analyst: Ralf Etzelmueller, Frankfurt, (49) 69-33-999-123

Secondary Credit Analysts: Eve Greb, Frankfurt, (49) 69-33-999-124

Amrit Gescher, London, (44) 20-7176-3733

RationaleThe ratings on Dubai-based port operator DPWorld Ltd. principally reflect Standard & Poor’sRatings Services’ expectation of sovereign supportbased on the company’s indirect ownership by thegovernment of Dubai and its pivotal role indiversifying the emirate’s revenues away from oiland fostering international expansion. DP Worldis a major international port operator and its key activities in Dubai benefit from a stronghub position. DP World also has geographicdiversification after recent large internationalacquisitions.

Like other port operators, DP World is exposedto the global economy and developinginternational trade streams, particularly to andfrom China and India. The company is also likelyto face heightened port competition fortransshipment along with increasing consolidationin the shipping industry.

Given DP World’s national importance,Standard & Poor’s has factored implicit sovereignsupport into the rating; there are, however, noformal guarantees. State support for DP World isdemonstrated by: the emirate’s 100% ownershipthrough its Dubai World holding company; theemirate’s direct influence over the companythrough Dubai World’s representation on DPWorld’s board, including the position ofchairman; the company’s strategic importance as aconduit for diversifying the economy of theemirate away from oil; and the previous tangiblefinancial, operational, and extraordinary supportfor the company’s activities. The company’s stand-alone rating is solid investment grade within the‘BBB’ rating category.

DP World benefits from a strong position in theglobal ports sector, where barriers to entry arehigh. The company has a highly diversifiedrevenue base in terms of location and cargo,significant sector experience, and a goodoperating track record. DP World is not anintegrated business, however, in that it is not, atpresent, a landlord. Within this context theemirate has demonstrated its support of DPWorld by awarding the company a 99-year leasefor the Jebel Ali port facility located in Dubai--against an industry norm of 20-50 years--whilemaking significant infrastructure investments inthe hinterland surrounding the port. Reflectingthe importance of the company to the emirate,Standard & Poor’s expects a significant

proportion of the company’s EBITDA to continueto be generated at the Jebel Ali and Port Rashidfacilities in the medium term.

Port activity is either as a transshipment hub orfor the import and export of goods for a regionor hinterland. The more a port relies ontransshipment, the more it is exposed to worldtrade development. The port sector, like shipping,is experiencing very brisk business due to thecurrent positive economic climate and, especially,China’s and India’s growth. Clearly, DP World’sports--like other ports--would be negativelyaffected in the event of a global economicdownturn or changes in trade patterns and/orvolumes. A potential industry downturn could beexacerbated by increasing bargaining power, dueto size, mounting concentration of containershipping companies, and intensifying competitionbetween ports for transshipment cargo.Furthermore, the company faces the potentialgeopolitical risk of the location of its main portasset--Jebel Ali--in the Gulf region.

DP World’s recent, sizable acquisitions includePeninsular & Oriental Steam Navigation Co.(P&O) and CSX World Terminals. The companyhas consequently faced the challenge ofintegrating these assets while maintaining existingperformance and deriving expected returns fromthe new acquisitions. Furthermore, although thecompany may have some degree of flexibility overits future capital expenditure program, it needs tomaintain its competitive position against otheroperators by investing in new technology andundertaking new projects, such as the recentlyannounced £1.5 billion investment in the complexLondon Gateway Port facility.

The company has a relatively aggressivefinancial profile. Debt leverage is likely toincrease, primarily as a result of the debtfinancing of capital expenditures. At the sametime, cash flow cover ratios are relatively low,leaving limited room for underperformance inexecuting future capital investment. There may beflexibility to postpone or cancel planned capitalexpenditures, however, should the need arise.

LiquidityAt Dec. 31, 2006, DP World benefited from morethan $2.2 billion in back-up liquidity, primarilythrough free cash of $1.7 billion. The company’sfuture primary liquidity will, however, beprovided via credit facilities of $0.5 billion. In

Publication Date:

June 13, 2007

Issuer Credit Rating:A+/Stable/A-1

Primary Credit Analyst:Jonathan Manley, London, (44) 20-7176-3952

Secondary Credit Analysts:Florian De Chaisemartin,London, (44) 20-7176-3760


DP WORLD LTD.




addition, DP World will likely be able to call onDubai World to provide liquidity, as has occurredpreviously to fund acquisitions.

OutlookThe stable outlook assumes that DP World willcontinue to benefit from its close strategicrelationship with, and ownership by, thegovernment of Dubai. Any indication that thegovernment’s support for the company hasweakened would result in a change in the ratingalthough, of itself, the sale of a minority stake in the company would be unlikely to affect the ratings.

The outlook also assumes that the companywill successfully execute its business plan andfulfill its financial forecasts, in the light of any global economic downturn,increased competition, and successful execution ofthe capital expenditure program, includingacquisitions. ■


RationaleThe ratings on Sanef are equalized with those onAbertis Infraestructuras S.A. (A/Negative/--).Following its privatization, Sanef is controlled byAbertis through 52.6%-owned Holdingd’Infrastructures de Transport S.A.S. (HIT;A/Negative/--), the intermediary vehicle thatacquired Sanef.

The rating on Abertis reflects the company’sexcellent business profile, with strong and stablecash flow generation derived largely from its toll-road concession business, a supportive regulatoryframework both in Spain and France, and fairlymanageable future capital-expenditure needs.These strengths are offset by Abertis’ weakenedfinancial profile and lack of dividend flexibility, aswell as its appetite for additional acquisitions,which could further impair its business andfinancial profile. It is important to note thatwithout this support, HIT and Sanef’s underlyingcredit quality would be significantly weaker. On acombined, stand-alone basis, HIT and Sanefwould have very low investment-grade ratings. IfAbertis’ continued acquisitive strategysignificantly reduces Sanef’s contribution toAbertis’ consolidated financial profile, HIT andSanef could be rated one notch below Abertis.

The ratings on Sanef reflect its strong marketposition as the third-largest interconnected toll-road network across key economic and touristcorridors in France, supportive concessionagreements, high profitability, and increasingpositive free cash flow generation. These strengthsare offset by Sanef’s exposure to traffic risk, aweakened financial profile following itsacquisition by HIT--particularly when HIT’s debtis factored in--and aggressive dividend payout toHIT limiting debt burden curtailment andexposing lenders to substantial refinancing risk.

In the financial year ended Dec. 31, 2006,Sanef’s consolidated EBITDA amounted to €809million, up 8.6% on 2005. EBITDA essentiallyderived from toll revenues, which grew 6% in2006, and should continue to represent 90% ormore of revenues over the medium term. Theunadjusted EBITDA margin increased to 66%.

Consolidated HIT and Sanef net debt peaked atabout €6.8 billion (excluding Sanef’s debtrevaluation following acquisition), in line withexpectations, at year-end 2006. With a

consolidated net-debt-to-EBITDA ratio of 8.7x,the companies were still comfortably complyingwith the consolidated covenants at HIT’s level(maximum ratio of 10.5x) at year-end 2006.Based on the consolidated covenants at the HITlevel, leverage is expected to decrease to 6.5x atyear-end 2012. Sanef’s group net debt at 5.2xEBITDA at year-end 2006 is still well below thethreshold of 7.0x set by Caisse Nationale desAutoroutes (AAA/Stable/--).

Liquidity Sanef’s liquidity is satisfactory, owing to steadycash flow generation stemming from the toll-road business.

Financing needs for 2007 include some €469million of debt maturing until Dec. 31, 2007, anda forecast €176 million dividend payment to HITbased on 100% payout of 2006 net income.These were partially covered by available cashand marketable securities of €223 million at year-end 2006 and expected positive free operatingcash flow (defined as funds from operations{FFO} plus working capital change, minus capitalexpenditures) of about €280 million in 2007,making debt refinancing necessary.

OutlookThe negative outlook mirrors that on Abertis andreflects mainly our concern that Abertis is nowpursuing a more aggressive acquisition strategyfollowing the purchase of a 32% stake in EutelsatCommunication S.A. (BB+/Stable/B), the holdingcompany of Eutelsat S.A.

We expect Abertis to be able to meet the targetratios we indicated on June 1, 2006: FFO to grossdebt of about 13%-15% and FFO interestcoverage of about 3.5x-4x. We expect Abertis toapproach the lower end of these ranges over thenext two years, and to make continuedimprovements toward the higher end of theranges thereafter.

Abertis does not have headroom for furtherdebt-financed acquisitions at the current ratinglevel. A stronger-than-originally-expected financialperformance could lead to a revision of theoutlook to stable on Abertis, and therefore onSanef and HIT. ■

SANEF


Publication Date:

June 7, 2007

Issuer Credit Rating:A/Negative/A-1

Primary Credit Analyst: Alexandre de Lestrange, Paris, (33) 1-4420-7316

Secondary Credit Analyst:Lidia Polakovic, London, (44) 20-7176-3985

RationaleThe ratings on VINCI S.A. reflect its strongmarket positions in a wide variety of concessionand construction activities, and the considerablecontribution from its stable and profitableconcession businesses--59% of pro formaoperating profit from ordinary activities in 2006.These strengths are mitigated by the capital-intensive nature of the concessions business, highleverage, the cyclical and relatively lower marginnature of construction activities, and VINCI’sacquisitive strategy.

At the beginning of 2007, VINCI increased itsstake in Cofiroute, and is to do so in Soletanche(subject to approval by antitrust authorities). Itacquired Nukem Ltd. and recently announcedthat it had agreed the acquisition of 41% ofEntrepose Contracting and will file a takeover bidcovering the remaining Entrepose Contractingshares within the next few days. Standard &Poor’s Ratings Services will monitor the impact ofVINCI’s flow of acquisitions on the group’sbusiness and financial risk profiles. The currentratings do not provide flexibility for any newlarge debt-financed acquisitions.

Overall, we view the recent acquisitions aspositive for VINCI’s business, even though theyhave increased leverage and pay-off for theCofiroute stake will only come when Cofiroutecompletes its large construction program in 2008.Given that VINCI had ownership in orcommercial involvement with these entities priorto the transactions, acquisition risk is limited.Nukem Ltd. and Entrepose Contracting willcomplement VINCI’s presence in value-added andspecialty businesses, while broadening geographiccoverage in rapidly growing markets.

The share buyback of 12 million of VINCIshares announced in September 2006 (to the tuneof more than €1 billion) has been factored intothe ratings. However, our concerns on howVINCI intends to finance further buybacks andover its appetite for further external growthcontribute to the negative outlook on the group.VINCI has, however, announced to investors thatit will be less active on the share buyback front ifinteresting external growth opportunities arise.

Acquisitions have delayed the improvement ofthe group’s financial profile and VINCI’s creditratios will weaken slightly in 2007 versus 2006,despite an expected strong operating performance.However, we still expect the company to achieve

a financial profile commensurate with the ‘BBB+’rating, strengthening funds from operations (FFO)to net debt and FFO to net interest to about 20%and 5.0x by 2010, respectively, from 15% andabout 4.5x in 2007. At year-end 2006 and on apro forma basis, adjusted FFO to net debt wasabout 16%, and adjusted FFO to net interestclose to 5.0x.

Short-term credit factorsThe ‘A-2’ short-term rating reflects VINCI’s goodliquidity, which stems from the group’s cash-generative toll road and construction businesses.Liquidity was supported by about € 5.5 billion ofcash and marketable securities at March 31 2007.VINCI also had € 5.7 billion fully available underfive- to seven-year revolving credit facilities (outof which € 3.9 billion is not subject to financialcovenants) maturing between 2011 and 2013.This figure includes ASF’s and Cofiroute’sfacilities. In addition, VINCI’s liquidity benefitsfrom a CP program--of which about € 1 billionwas used at March 31, 2007--and positive freecash flow generation.

A downgrade or negative CreditWatchplacement of the ratings on VINCI following awinding up or dissolution of the company wouldallow bondholders to demand early redemption ofthe € 1 billion bonds maturing 2009, and in this case refinancing would be required. A normalacquisition would not trigger early redemption,however.

Early redemption of the € 1 billion bonds couldalso be required if VINCI is placed onCreditWatch negative following the transfer of aprincipal subsidiary’s undertakings and assets.Principal subsidiary refers to a 51%-owned (85%for Cofiroute) subsidiary accounting for morethan 1% of total sales, where the group has aboard majority. We do not, however, expect anytransfer of assets that would lead to earlyredemption of the bonds.

VINCI’s € 500 million hybrid issued inFebruary 2006 does not include a change ofcontrol clause.

OutlookThe negative outlook reflects our concerns thatdebt-financed acquisitions and share buybacksfurther to those we have already factored into theratings could weaken VINCI’s financial profileand delay the achievement of target ratios.


VINCI S.A.


Publication Date:

June 11, 2007

Issuer Credit Rating:BBB+/Negative/A-2

Primary Credit Analyst:Alexandre de Lestrange, Paris, (33) 1-4420-7316

Secondary Credit Analyst:Hugues De La Presle, Paris, (33) 1-4420-6666

To sustain a ‘BBB+’ rating, VINCI’s strongbusiness risk profile requires continuing supportfrom its solid and mature concessions businesses,which provide about two-thirds of EBITDA.

The ratings will be lowered if the financialprofile deteriorates or the target ratios are notmet by 2010. Beyond what we have alreadyfactored into the rating in terms of acquisitions,share buybacks, public private partnership (PPP)investments, and dividends, there is very littleheadroom for a weakening in the financial profile.We have not assumed a further increase inVINCI’s ownership of Cofiroute.

The outlook could revert to stable if it becomesclear that the company will achieve its targetratios by 2010, meeting our strategy expectations.The improvement of VINCI’s credit metrics ispredicated on improved cash flow generation,rather than debt reduction. ■




PROJECT FINANCE AND PUBLIC-PRIVATE PARTNERSHIPS

PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS

Our project finance ratings, including those for public-private partnerships (PPPs), remainrelatively stable. Notwithstanding this, 2007 has continued to present credit challenges to thesector.

The £1.6 billion debt-financed Metronet London Underground PPP projects, for example, entered PPPadministration as the capital cost and progress of undertaking the upgrade works outstrippedexpectations. While the resolution of this situation is yet to unravel, the £2.8 billion launch of theChannel Link Enterprises transaction marked the rebirth of the Eurotunnel project--albeit following asignificant reduction in debt.

Our coverage of projects and PPPs continues to grow, particularly in the U.K. PPP sector for schoolsand hospitals, in road projects throughout Europe, and natural resource projects in the Middle East.Furthermore, increased activity has been noted in the project finance CLO market--where banks seek totransfer credit risk on existing project finance loans--as effective ways of recycling capital are sought.Although only one such transaction launched in 2007 (Smart PFI 2007), many wait in the wings untilstability returns to the credit markets.

During 2007, Standard & Poor’s updated its criteria for analyzing project finance transactions. Whilethe overall framework for evaluation remains the same, our criteria has evolved to reflect the pace ofchange presented by the project finance market. Globally Standard & Poor’s has identified increasingrisks and complexity in project structures, including accreting swaps, the introduction of facilitiesinstead of reserves to support liquidity, and the removal of “debt-free” tails. All of these areas, andothers, have been considered by the global analytical teams in the past year and, no doubt, 2008 andbeyond will continue to present new challenges.

As the infrastructure market has, at least until recent months, remained very much the focus ofattention, so has the application of project finance techniques to corporate acquisition structures. Thesponsors’ aim has been to isolate the acquired structure from their ownership. This has often proven tobe a challenge and, in effect, a hybrid market has evolved that reflects the characteristics of corporatefinance but with some of the structural protection of project finance. Although there are benefits fromcertain protections, it has proven elusive for many airport and port assets, for example, to fully mitigatethe highly aggressive financial risk.

We expect ratings to remain stable overall, as projects and PPPs are likely to continue to be structuredto ensure relative operating stability. Nevertheless, counterparty risk such as the insolvency ofcontractors, inadequate estimates of future costs, and increasing construction costs in the Middle Eastpresent challenging credit factors that we will continue to monitor.

Jonathan MManleySenior Director and Co-Team LeaderProject Finance and Transportation Infrastructure

Lidia PPolakovicSenior Director and Co-Team LeaderProject Finance and Transportation Infrastructure


The world of project finance has continuedto grow since Standard & Poor’s publishedits last comprehensive rating criteria.

Project financing has become increasinglysophisticated and often riskier, with a widerinvestor base attracting new finance structuresand investors across the globe. We have closelyfollowed these developments over the years,extending and revising our criteria from time totime to enable appropriate assessment of project-finance risk originating from new markets, newstructures, and new avenues of ownership.Factoring different market circumstances into ouranalysis remains challenging, but globalconsistency of our criteria and approach has beenour prime objective in responding to these newmarket developments. The combined magnitudeof these criteria additions and changes is notgreat; it is, rather, more of a rearrangement thatbetter reflects current practice and changes toassociated criteria, such as recovery aspects.

Additionally, we want to note that we haverevised certain aspects of our internal analyticalframework for rating projects, and stress thatalthough we have adopted one significant change--eliminating our scoring approach--no ratingswill be affected. We introduced scoring six yearsago to facilitate the compare-and-contrast of keyproject risks across the spectrum of rated projects.The scores, and the criteria on which they werebased, represented only guidelines. Scores werenever meant to be additive, but nevertheless,many readers understood them as such. Becausethe scoring caused confusion among some users ofour criteria, we decided to remove those suggestedscores and focus more on other analytical tools tocompare risk across projects. In response to thechanging world of project finance and theblurring of boundaries from pure project-financetransactions to hybrid structures, our analysis hasbeen expanded and now incorporates somecorporate analytical practice, to look at acombination of cash-flow measures, capitalstructure, and liquidity management.

We also have reincorporated our assessment offorce majeure risk into our analysis of a project’scontractual foundation and technical risk, ratherthan addressing these as a separate risk category.

The overall criteria framework has not beenchanged, however, and still provides a veryeffective framework for analyzing andunderstanding the risk dynamics of a project transaction.

Recent TrendsAs project finance continues to adjust to theincreasingly diverse needs of project sponsors,their lenders, and investors, in many cases theanalysis of risk continues to grow in complexity.Despite this growing variety of project-financeapplication and location, the continuing marketdesire for nonrecourse funding solutions suggeststhat project finance will remain a robust means ofraising infrastructure capital. More aggressivefinancial structures sometimes blur the boundariesof nonrecourse finance both in reality andperception. Also, the greater exposure to marketrisk has forced many sponsors to seek greaterflexibility in project structures to manage cash,take on additional debt, and enter new businesseswith few restrictions--which makes some projectslook more like corporates.

Projects continue to evolve from theirtraditional basis of long-term contracted revenue,and now involve a greater exposure to a numberof risks. Initial project finance primarily wasfocused on power markets that had strongcontractual bases; but these days, more projectsare exposed to the risks of volatile commoditymarkets or traffic volume exposure, among othertypes. Strong global demand for construction andcommodities has increased construction risk, evenfor simple projects.

Fewer projects have been able to secure themore creditor-friendly fixed-price, turnkey, date-certain construction contracts that better protectlenders from construction and completion risk.Term B loan structures--“mini-perms”, withminimal amortizations and risky bullet maturities--have established themselves firmly in the projectworld, but these capital plans have now beenjoined by more complex first- and second-lienstructures, and more debt within holding-company structures, particularly for payment-in-kind instruments that we view essentially as debt.

Many long-term concession projects aremaximizing leverage by employing accreting debtstructures that enable sponsors to recoup quickequity returns--sometimes before any debt hasbeen repaid--but that can greatly increase lenders’exposure to default risk in the later years (see“Credit FAQ: Accreting Debt Obligations AndThe Road To Investment Grade For InfrastructureConcessions” on page 105). Private equity hasmade strong inroads to project lending andownership--either directly or through managedinfrastructure funds. The trend away from

UPDATED PROJECT FINANCE SUMMARY DEBTRATING CRITERIA


Publication Date:

Sept. 18, 2007

Primary Credit Analysts: Terry A Pratt, New York, (1) 212-438-2080

Ian Greer, Melbourne, (61) 3-9631-2032

Arthur F Simonson, New York, (1) 212-438-2094

Secondary Credit Analyst: Lidia Polakovic, London, (44) 20-7176-3985



ownership by experienced sponsors raises newconcerns about ownership and long-termoperational performance. Positively, the usage ofproject finance is growing in part thanks to thesenew structures. In particular, financing of public-private partnerships (PPPs) has grownsignificantly over the years, with PPPs oftenconsidered to be a lower-risk investment due tothe involvement of a public authority orgovernment entity.

Another observation is the increase of insuredproject finance transactions. Monoline insurancecompanies providing guarantees for timely-and-full debt servicing in cases of projects beingunable to do so has opened different investmentopportunities for the financial markets. However, we closely monitor and analyze theunderlying risk of these projects to determine theunderlying credit quality, as a part of the insuredrating exercise.

Finally, the emergence of the Middle Eastmarkets as one of the largest global markets ofproject finance has challenges of its own. Drivenby low default track records and stronggovernment support or sponsorship, these projectshave created a class of their own in terms ofinvestors’ perception of risk allocation. MiddleEast project finance is an area that remains undercriteria development while we aim to adequatelyweigh up the hard facts, such as risk structure andallocation, terms and conditions of projectfinancings in the region, and stated support from governments.

General ApproachFor lenders and other investors, systematicidentification, comparison, and contrasting ofproject risk can be a daunting task, particularlybecause of the new complexity presented toinvestors. To assess project-finance risk, Standard& Poor’s continues to use a framework based onthe traditional approach that grew out of ratingU.S. independent power projects but which hasbeen adapted to cover a growing range of otherprojects globally, such as more complextransportation schemes, stadiums and arenas,hotels and hospitals, and renewable energies.

Our approach begins with the view that aproject is a collection of contracts and agreementsamong various parties, including lenders, whichcollectively serves two primary functions. The

first is to create an entity that will act on behalfof its sponsors to bring together several uniquefactors of production or activity to generate cashflow from the sale/provision of a product orservice. The second is to provide lenders with thesecurity of payment of interest and principal fromthe operating entity. Standard & Poor’s analyticframework focuses on the risks of constructionand operation of the project, the project’s long-term competitive position, its legalcharacterization, and its financial performance--inshort, all the factors that can affect the project’sability to earn cash and repay lenders.

“Project Finance“ DefinedA project-finance transaction is a cross between astructured, asset-backed financing and a corporatefinancing. A project-finance transaction typicallyis characterized as nonrecourse financing of asingle asset or portfolio of assets where thelenders can look only to those specific assets togenerate the cash flow needed to service its fixedobligations, chief of which are interest paymentsand repayment of principal. Lenders’ security andcollateral is usually solely the project’s contractsand physical assets. Lenders typically do not haverecourse to the project’s owner, and often,through the project’s legal structure, projectlenders are shielded from a project owner’sfinancial troubles.

Project-finance transactions typically arecomprised of a group of agreements and contractsbetween lenders, project sponsors, and otherinterested parties who combine to create a formof business organization that will issue a finiteamount of debt on inception, and will operate ina focused line of business over a finite period.There are many risks that need to be analyzedwhen rating a project-finance transaction;however the chief focus within Standard & Poor’srating process is the determination of the project’sstability of projected cash flow in relation to theprojected cash needs of the project. This criteriaarticle addresses the areas on which we focuswhen conducting analysis, and how this translatesinto a rating on a project-finance transaction as awhole. For each focus area, we gauge the relativeimportance for the project being rated and theimpact that focus area could have on the project’soverall cash-flow volatility. The process is verysystematic, but is tailored to each project rating.

The ratingStandard & Poor’s project debt ratings addressdefault probability--or, put differently, the level ofcertainty with which lenders can expect to receivetimely and full payment of principal and interestaccording to the terms of the financingdocuments. Unlike corporate debt, project-financedebt is usually the only debt in the capitalstructure, and typically amortizes to a schedulebased on the project’s useful life. Importantly, alsounlike our corporate ratings, which reflect riskover three-to-five years, our project debt ratingsare assigned to reflect the risk through the debt‘stenor. If refinancing risk is present, weincorporate into the rating the ability of theproject to repay the debt at maturity solely fromthe project sources. Our project ratings oftenfactor in construction risk, which in many casescan be higher than the risk presented by expectedoperations once the project is completed. In somecases, the construction risk is mitigated by otherfeatures, which enables the debt rating to reflectour expectations of long-term post-constructionperformance. Otherwise, we will rate to theconstruction risk, but note the potential forratings to rise once construction is complete.

Another important addition to our project-debt ratings is the recovery rating concept thatStandard & Poor’s began to assign to secureddebt in late 2003. The recovery rating estimatesthe range of principal that lenders can expect toreceive following a default of the project. Ourrecovery scale is defined in table 1. We define thelikely default scenario, and then assess recoveryusing various techniques, such as discounted cash-flow analysis or EBITDA multiples. Or, we willexamine the terms and conditions of projectassets, such as contracts and concession

agreements, for example, to estimate the expectedrecovery. The added importance of the recoveryrating is that recovery can affect the ratings oncertain classes of project debt when more thanone class of debt is present.

Framework for Project Finance CriteriaThorough assessment of project cash flowsrequires systematic analysis of five principlefactors:

• Project-level risk• Transactional structure• Sovereign risk• Business and legal institutional

development risk• Credit enhancements

Project-Level RisksProject-level risk, or the risks inherent to aproject’s business and within its operatingindustry, will determine how well a project cansustain ongoing commercial operationsthroughout the term of the rated debt and, as aconsequence, how well the project will be able toservice its obligations (financial and operational)on time and in full.

Specifically, we look at a project’s: • Contractual foundation. Operational and

financing contracts--such as offtake agreements, concessions, construction arrangements, hedge agreements, loan contracts, guarantees--that, along with the physical plant, serve as the basis of the enterprise.

• Technology, construction, and operations. Does it have a competitive, proven technology, can construction be performed on time and on budget, and can it operate ina manner defined under the base case?

• Resource availability. Capacity to incorporate “input” resources, such as wind or natural gas.

• Competitive-market exposure. Competitive position against the market in which it will operate.

• Counterparty risk. Risk from relying on suppliers, construction companies, concession grantors, and customers.

• Financial performance. Risks that may affectforecast results, and cash-flow variability under likely stress scenarios.



Recovery Recovery Recovery rating description expectations*

1+ Highest expectation, 100%¶full recovery

1 Very high recovery 90%-100%

2 Substantial recovery 70%-90%

3 Meaningful recovery 50%-70%

4 Average recovery 30%-50%

5 Modest recovery 10%-30%

6 Negligible recovery 0%-10% *Recovery of principal plus accrued but unpaid interest at the time ofdefault. ¶Very high confidence of full recovery resulting from significantovercollateralization or strong structural features.

Table 1 - Standard & Poor’s Recovery Scale


Contractual foundationWe analyze a project’s contractual composition tosee how well the project is protected from marketand operating conditions, how well the variouscontracted obligations address the project’soperating-risk characteristics, and how thecontractual nexus measures up against otherproject contracts.

The structure of the project should protectstakeholders’ interests through contracts thatencourage the parties to complete project-construction satisfactorily and to operate theproject competently in line with the requirementsof the various contracts. The project’s structurealso should give stakeholders a right to a portionof the project’s cash flow so that they can servicedebt, and should provide for the releasing of cashin the form of equity distributions (dividends orother forms of shareholder payments) inappropriate circumstances. Moreover, higher-ratedprojects generally give lenders the assurance thatproject management will align their interests withlenders’ interests; project management shouldhave limited discretion in changing the project’sbusiness or financing activities. Finally, higher-rated projects usually distinguish themselves fromlower-rated projects by agreeing to give lenders afirst-perfected security interest (or fixed charge,depending on the legal jurisdiction) in all of theproject’s assets, contracts, permits, licenses,accounts, and other collateral; in this way theproject can either be disposed of in its entiretyshould the need arise, or the lenders can step in toeffectively replace the project’s management andoperation so as to generate cash for debtservicing.

As infrastructure assets have becomeincreasingly popular for concessions, not only isthe analysis of the strengths and weaknesses ofthe concession critical but, also the rationale forthe concession becomes an essential element ofour analysis. Contract analysis focuses on theterms and conditions of each agreement. Theanalysis also considers the adequacy and strengthof each contract in the context of a project’stechnology, counterparty credit risk, and themarket, among other project characteristics.

Commercial versus collateral agreements.Project-contract analysis falls into two broadcategories: commercial agreements and collateralarrangements.

Commercial project contracts analysis isconducted on contracts governing revenue andexpenses, such as:

• Power purchase agreements;• Gas and coal supply contracts;• Steam sales agreements;• Liquefied natural gas sales agreements;• Concession agreements;• Airport landing-fee agreements;• Founding business agreement; and• Any other agreements necessary for the

operations of the project.

Collateral agreements typically require analysisof a project’s ownership along with financial andlegal structures, such as:

• Credit facilities or loan agreement;• Indenture;• Equity-contribution agreement;• Mortgage, deed of trust, or similar

instrument that grants lenders a first-mortgage lien on real estate and plant;

• Security agreement or a similar instrument that grants lenders a first-mortgage lien on various types of personal property;

• Assignments to lenders of project assets, accounts, and contracts;

• Project-completion guarantees;• Depositary agreements, which define how

the project cash is handled;• Shareholder agreements;• Collateral and inter-creditor agreements; and• Liquidity-support agreements, such as letters

of credit (LOCs), surety bonds, and targeted insurance policies.

An important objective of our contractualassessment is the understanding of a project’s fullrisk exposure to potential force majeure risks, andhow the project has mitigated such risk. Projectfinancings rely on asset and counterpartyperformance, but force majeure events can excuseperformance by parties when they are confrontedwith unanticipated events outside their control. A careful analysis of force majeure events iscritical in a project financing because such events,if not properly recompensed, can severely disruptthe careful allocation of risk on which thefinancing depends. Floods and earthquakes, civildisturbances, strikes, or changes of law candisrupt a project’s operations and devastate itscash flow. In addition, catastrophic mechanical


failure due to human error or material failure canbe a form of force majeure that may excuse aproject from its contractual obligations. Despiteexcusing a project from its supply obligations, theforce majeure event may still lead to a defaultdepending on the severity of the mishap.

Technology, construction, and operationsIn part, a project’s rating rests on thedependability of a project’s design, construction,and operation; if a project fails to achievecompletion or to perform as designed, manycontractual and other legal remedies may fail tokeep lenders economically whole.

The technical risk assessment falls into twocategories: construction and operations.

Construction risk relates to:■Engineering and design■Site plans and permits■Construction■Testing and commissioning

Operations risk relates to:■Operations and maintenance (O&M)

strategy and capability■Expansion if any contemplated■Historical operating record, if any

Project lenders frequently may not adequatelyevaluate a project’s technical risk when making aninvestment decision but instead may rely on thereputation of the construction contractor or theproject sponsor as a proxy for technical risk,particularly when lending to unrated transactions.The record suggests that such confidence may bemisplaced. Standard & Poor’s experience withtechnology, construction, and operations risk onmore than 300 project-finance ratings indicatesthat technical risk is pervasive during the pre- andpost-construction phases, while the possibility ofsponsors coming to the aid of a troubled projectis uncertain. Thus, we place considerableimportance on a project’s technical evaluation.

We rely on several assessments to complete ourtechnical analysis. One key element is a reputableindependent expert’s (IE) project evaluation. Weexamine the IE’s report to see if it has the properscope to reach fundamental conclusions about theproject’s technology, construction plan, andexpected operating results, and then we determinewhether these conclusions support the sponsor’s

and EPC contractor’s technical expectations. Wesupplement our review of the IE’s report withmeetings with the IE and visits to the site toinspect the project and hold discussions with theproject’s management and construction contractoror manager. Without an IE review, Standard &Poor’s will most likely assign a speculative-gradedebt rating to the project, regardless of whetherthe project is in the pre- or post-constructionphase. Finally, we will assess the project’stechnical risk using the experience gained fromexamining similar projects.

Another key assessment relates to the potentialcredit effect of a major equipment failure thatcould materially reduce cash flow. This analysisgoes hand-in-hand with the contractualimplications of force majeure events, describedabove, and counterparty risk, described below. Ifthe potential credit risk from such an event is notmitigated, then a project’s rating would benegatively affected. Mitigation could be in theform of business-interruption insurance, cashreserves, and property casualty insurance. Thelevel of mitigation largely depends on the projecttype--some types of projects, such as pipelines andtoll roads--are exposed to low outage risks andthus could achieve favorable ratings with onlymodest risk mitigation. In contrast, amechanically complex, site-concentrated project--such as a refinery or bio-mass plant--can behighly exposed to major-equipment-failure risk,and could require robust features to deal with potential outages that could take months to repair.

Resource availabilityAll projects require feedstock to produce output,and we undertake a detailed assessment of aproject’s ability to obtain sufficient levels. Formany projects, the input-supply risk largely hingeson the creditworthiness of the counterparty that isobligated to provide the feedstock, which isdiscussed below under Counterparty Exposure.Other types of projects, however, such as windand geothermal power, rely on the type of naturalresources of which few third parties are willing toguarantee production. In these cases, we requirean understanding of the availability of the naturalresource throughout the debt tenor. We usevarious tools to reach our conclusions, but mostimportant will be the analysis and conclusions ofa reputable IE or market consultant on the



resource sufficiency throughout the debt tenor. Inmany cases, such as wind, where the assessmentcan be highly complex, we may require twosurveys to get sufficient comfort. Just as with IEtechnical reports, a project striving forinvestment-grade and high speculative-graderatings will require a strong resource-assessmentreport. However, given the potential foruncertainty in many resource assessments,stronger ratings are likely to require either morethan one IE resource assessment, geographicdiversity, or robust liquidity features to meet debt-repayment obligations if the resource does notperform as expected.

Competitive market exposureA project’s competitive position within its peergroup is a principal credit determinant, even if theproject has contractually-based cash flow.Analysis of the competitive market positionfocuses on the following factors:

• Industry fundamentals• Commodity price risk• Supply and cost risk• Regulatory risk• Outlook for demand• Foreign exchange exposure• The project‘s source of competitive

advantage• Potential for new entrants or disruptive

technologies

Given that many projects produce a commoditysuch as electricity, ore, oil or gas, or some form oftransport, low-cost production relative to themarket characterizes many investment-graderatings. High costs relative to an average marketprice in the absence of mitigating circumstanceswill almost always place lenders at risk; butcompetitive position is only one element ofmarket risk. The demand for a project’s outputcan change over time (seasonality or commoditycycles), and sometimes dramatically, resulting inlow clearing prices. The reasons for demandchange are many, and usually hard to predict.Any of the following can make a project more orless competitive:

• New products• Changing customer priorities• Cheaper substitutes• Technological change• Global economic and trade developments

Experience has shown, however, that offtakecontracts providing stable revenues or that limitcosts, or both, may not be enough to mitigateadverse market situations. As an example,independent power producers in California had torestructure parts of fixed-price offtake agreementswhen the utilities there came under severefinancial pressure in 2000 and 2001. Hence,market risk can potentially take on greaterimportance than the legal profile of, and securityunderlying, a project. Conversely, if a projectprovides a strategic input that has few, if any,substitutes, there will be stronger economicincentives for the purchaser to maintain a viablerelationship with the project.

Counterparty exposureThe strength of a project financing rests on theproject’s ability to generate stable cash flow aswell as on its general contractual framework, butmuch of a project’s strength comes fromcontractual participation of outside parties in theestablishment and operation of the projectstructure. This participation raises questionsabout the strength and reliability of suchparticipants. The traditional counterparties toprojects have included raw-material suppliers,principal offtake purchasers, and EPCcontractors. Even a sponsor becomes a source ofcounterparty risk if it provides the equity duringconstruction or after the project has exhausted itsdebt funding.

Other important counterparties to a project caninclude:

• Providers of LOCs and surety bonds;• Parties to interest rate and currency swaps;• Buyers and sellers of hedging agreements

and other derivative products;• Marketing agents;• Political risk guarantors; and• Government entities.

Because projects have taken on increasinglycomplex structures, a counterparty’s failure canput a project’s viability at risk.

Standard & Poor’s generally will not rate aproject higher than the lowest rated entity (e.g.,the offtaker) that is crucial to projectperformance, unless that entity may be easilyreplaced, notwithstanding its insolvency or failureto perform. Moreover, the transaction rating may



also be constrained by a project sponsor’s rating ifthe project is in a jurisdiction in which thesponsor’s insolvency may lead to the insolvency ofthe project, particularly if the sponsor is the soleowner of the project.

During construction, often the project debtrating could be higher than the credit quality ofthe builder by credit enhancement and wherethere is an alternate builder available (see “CreditEnhancements (Liquidity Support) In ProjectFinance And PPP Transactions Reviewed,”published on RatingsDirect on March 30, 2007).

Financial performanceStandard & Poor’s analysis of a project’s financialstrength focuses on three main attributes:

• The ability of the project to generate sufficient cash on a consistent basis to pay its debt service obligations in full and on time;

• The capital structure and in particular debt paydown structure; and

• Liquidity.

Projects must withstand numerous financialthreats to their ability to generate revenuessufficient to cover operating and maintenanceexpenses, maintenance expenditures, taxes,insurance, and annual fixed charges of principaland interest, among other expenses. In addition,nonrecurring items must be planned for.Furthermore, some projects may also have to dealwith external risk, such as interest rate andforeign currency volatility, inflation risk, liquidityrisk, and funding risk. We factor into our creditevaluation the project’s plan to mitigate thepotential effects on cash flow that could becaused by these external risks should they arise.

Standard & Poor’s relies on debt-servicecoverage ratios (DSCRs) as the primaryquantitative measure of a project’s financial creditstrength. The DSCR is the cash-basis ratio of cashflow available for debt service (CFADS) to interestand mandatory principal obligations. CFADS iscalculated strictly by taking cash revenues fromoperations only and subtracting cash operatingexpenses, cash taxes needed to maintain ongoingoperations, and cash major maintenance costs,but not interest. As an operating cash-flownumber, CFADS excludes any cash balances that aproject could draw on to service debt, such as thedebt-service reserve fund or maintenance reserve

fund. To the extent that a project has taxobligations, such as host-country income tax,withholding taxes on dividends, and interest paidoverseas, etc., Standard & Poor’s treats thesetaxes as ongoing expenses needed to keep aproject operating (see “Tax Effects on DebtService Coverage Ratios,” published onRatingsDirect on July 27, 2000).

In our analysis, we examine the financialperformance of the project under base-case andnumerous stress scenarios. We select our stressscenarios on a project-by-project basis, given thateach project faces different risks. We avoidestablishing minimum DSCRs for different ratinglevels because once again, every project hasdifferent economic and structural features.However, we do require that investment-gradeprojects have strong DSCRs--well above 1.0x--under typical market conditions that we think areprobable, to reflect the single-asset nature of thebusiness. Strong projects must show very stablefinancial performance under a wide range ofstress scenarios. We also note that DSCRs forproject with amortizing debt may not be directly comparable to DSCRs for a project usingcapital structures that involve a small annualmandatory principal repayment--usually around1%--coupled with a cash-flow sweep to furtherreduce principal balances.

Capital structure.Standard & Poor’s considers a project’s capitalstructure as part of any rating analysis. A projectusually combines high leverage with a limitedasset life, so the project’s ability to repay largeamounts of debt within the asset lifetime is a keyanalytical consideration and one of the primarydifferences between rating a project and a typicalcorporate entity. The same holds true for projectsthat derive their value from a concession, such asa toll road, without which the ‘project’ has novalue; these concession-derived project financingslikely have very long asset lives that extend wellbeyond the concession term, but nevertheless the project needs to repay debt before theconcession expiration. Projects that rely on cashbalances to fund final payments demonstrateweaker creditworthiness.

Refinancing risk associated with bulletmaturities typical of corporate or publicfinancings are becoming more common in project-finance transactions. Examples include Term Loan



B structures, in which debt is repaid throughminimal mandatory amortizations--usually 1%per year--coupled with a debt repayment from aportion of distributable cash flow. While thesestructures certainly reduce default risk due tolower mandatory principal repayments, theyalmost always involve a planned refinancing ataround seven-to-eight years. In these types ofarrangements, our credit analysis determines if theproject can refinance debt outstanding at maturitysuch that it fully amortizes within the remainingasset life on reasonable terms.

The finite useful life of projects also introducescredit risk from an operational standpoint. Givenits depreciating characteristics, an aging projectmay find it more difficult to meet a fixedobligation near the end of its useful life. Thus, forprojects in which the useful life is difficult todetermine, those structured with a declining debtburden over time are more likely to achievehigher credit ratings than projects those that do not.

Many projects with high leverage seek capitalstructures that involve second-lien debt,subordinated debt, and payment-in-kindobligations. These structures and instruments areused to tap different investor markets and bufferthe senior-most debt from default risk. Theseother classes of debt are issued either at theoperating project or at the holding company thatwholly owns the project. Although such structurescan be helpful for senior debt, it obviously is tothe detriment of the credit quality of thesubordinated debt because in most cases this debtclass is inferior to senior lenders’ rights to cashflow until senior debt is fully repaid, or tocollateral in the event of a bankruptcy.

When looking at the creditworthiness ofsubordinate debt, the DSCR calculation is notCFADS to subordinate debt interest and principal,but is, rather, total cash available within the entireproject--after payments of all expenses andreserve filling--divided by both senior andsubordinate debt service. Such a formula moreaccurately measures the subordinated paymentrisk. This differs from the notching applied incorporate ratings, and the actual rating might belower than the coverage ratio implies, dependingon the level of structural lock-up and separationof senior debt.

Another analytical approach for multiple-debt-type structures is to examine the performance ofthe project with all of the debt on a consolidatedbasis, and then determine the risk exposure forthe different classes of debt based on structuralfeatures of the deal and provisions within the financing documents. To the extent that seniordebt is advantaged, lesser obligations are penalized.

Liquidity.Liquidity is a key part of any analysis, becauselenders rely on a single asset for debt repayment,and all assets types have unexpected problemswith unforeseen consequences that must be dealtwith from time to time.

Liquidity that projects typically have included: • A debt-service reserve account, to help meet

debt obligations if the project cannot generate cash flow due to an unexpected and temporary event. This reserve is typically sized at six months of annual debt service, although amounts can be higher as a result of specific project attributes (e.g., strong seasonality to cash flow, annual debt payments, etc.) The reserve should be cash or an on-demand cash instrument. However,if the reserve is funded with an LOC, we will factor in the potential for the additional debt burden that would occur if the reserve is tapped to help meet debt obligations. A maintenance reserve account is expected for projects in which capital expenditures are expected to be lumpy or where there is some concern about the technology being employed. Almost all investment-grade projects have such a reserve. We do not establish minimum funding level for these reserves, but gauge the need based on the findings of the IE’s technical evaluation and our experience.

• Look-forward-and-back distribution and lock-up tests to preserve surplus but lower than expected cash flows. For investment-grade consideration, a project structure will typically have a minimum of 12 months look forward and look back. The DSCR hurdle that should allow distribution is project dependent. The test ensures cash is retained to meet the projects liquidity needs in times of stress.



Transactional StructureStandard & Poor’s performs detailed assessmentof the project’s structural features to determinehow they support the project’s ability to performand pay obligations as expected. Key itemsinclude assessing if the project is structured to bea single-purpose entity (SPE), how cash flow ismanaged, and how the insolvency of entitiesconnected to the project (sponsors, affiliatesthereof, suppliers, etc.), who are unrated or arerated lowly, could affect project cash flow.

Special-purpose entities (SPEs)Projects generally repay debt with a specificrevenue stream from a single asset, and since forprojects we rate to debt maturity, we need to haveconfidence that the project will not take on otheractivities or obligations that are not defined whenthe rating is assigned. When projects are dulystructured as and remain SPEs, we can have moreconfidence in project performance throughout thedebt tenor. If such limitations are absent, wewould tend to rate a project more like acorporation, which would typically assume highercredit risk. Standard & Poor’s defines a project-finance SPE as a limited-purpose operating entitywhose business purposes are confined to:

• Owning the project assets;• Entering into the project documents (e.g.,

construction, operating, supply, input and output contracts, etc.);

• Entering into the financing documents (e.g., the bonds; indenture; deeds of mortgage; and security, guarantee, intercreditor, common terms, depositary, and collateral agreements, etc.); and

• Operating the defined project business.

The thrust of this single-purpose restriction isthat the rating on the debt obligations represents,in part, an assessment of the creditworthiness ofspecific business activities and reduces potentialexternal influences on the project.

One requirement of a project-finance SPE isthat it is restricted from issuing any subsequentdebt that is rated lower than its existing debt. Theexceptions are where the potential new debt wasfactored into the initial rating, debt issubordinated in payment, and security to theexisting debt does not constitute a claim on theproject. A second requirement is that the projectshould not be permitted to merge or consolidate

with any entity rated lower than the rating on theproject debt. A third requirement is that theproject (as well as the issuer, if different)continues in existence for as long as the rateddebt remains outstanding. The final requirementis that the SPE have an anti-filing mechanism inplace to hinder an insolvent parent from bringingthe project into bankruptcy. In the U.S., this canbe achieved by the independent-directormechanism, whereby the SPE provides in itscharter documents a specification that a voluntarybankruptcy filing by the SPE requires theconsenting vote of the designated independentmember of the board of directors (the boardgenerally owing its fiduciary duty to the equityshareholder[s]). The independent director’sfiduciary duty, which is also to the lenders, wouldbe to vote against the filing. In other jurisdictions,the same result is achieved by the “golden share”structure, in which the project issues a specialclass of shares to some independent entity (suchas the bond trustee), whose vote is required for avoluntary filing.

The anti-filing mechanism is not designed toallow an insolvent project to continue operatingwhen it should otherwise be seeking bankruptcyprotection. In certain jurisdictions, anti-filingcovenants have been enforceable, in which casesuch a covenant (and an enforceability opinionwith no bankruptcy qualification) would suffice.In the U.K. and Australia, where a first “fixedand floating” charge may be granted to thecollateral trustee as security for the bonds, thecollateral trustee can appoint a receiver toforeclose on and liquidate the collateral without astay or moratorium, notwithstanding theinsolvency of the project debt issuer. In suchcircumstances, the requirement for anindependent director may be waived.

The SPE criteria will apply to the project (andto the issuer if a bifurcated structure isconsidered), and is designed to ensure that theproject remains nonrecourse in both directions: byaccepting the project’s debt obligations, investorsagree that they will not look to the credit of thesponsors, but only to project revenues andcollateral for reimbursement; investors, on theother hand, should not be concerned about thecredit quality of other entities (whose risk profilewas not factored into the rating) affecting projectcash flows.

Where the project acts as operator, the analysis



will look to the ability of the project to undertakethe activities on a stand-alone basis, and any linksto external parties.

Cash managementNearly all project structures employ anindependent trustee to control all cash flow theproject generates, based on detailed projectdocuments that define precisely how cash is to bemanaged. This arrangement helps prevent cashfrom leaking out of the project prior to thepayment of operating expenses, majormaintenance, taxes, and debt obligations. In thosecases where there is no trustee, thecreditworthiness of the project will be linkeddirectly to the cash manager, which is usually thesponsor. Projects seeking investment-grade ratingswill have cash-management structures thatprevent any distributions to sponsors--includingtax payments--unless all expenses are fully paid,reserves are full, and debt-service coverage rationslooking back and forward for a sufficient periodare adequate.

Sovereign RiskA sovereign government can pose a number ofrisks to a project. For example, it could restrictthe project’s ability to meet its debt obligations byway of currency restrictions; it could interferewith project operations; and, in extreme cases,even nationalize the project. As a general rule, therating on a project issue will be no higher thanthe local-currency rating of the project in its hostcountry. For cross-border or foreign currency-denominated debt, the foreign currency rating ofthe country in which the project is located is thekey determinant, although in some instances debtmay be rated up to transfer and convertibility(T&C) assessments of the country Standard &Poor’s has established. A T&C assessment is therating associated with the probability of thesovereign restricting access to foreign exchangeneeded for servicing debt obligations. For mostcountries, Standard & Poor’s analysis concludesthat this risk is less than the risk of sovereigndefault on foreign currency obligations; thus,most T&C assessments exceed the sovereignforeign currency rating. A non-sovereign projectcan be rated as high as the T&C assessment if itsstress-tested operating and financialcharacteristics support the higher rating.

A sovereign rating indicates a sovereign

government’s willingness and ability to service itsown obligations on time and in full. Thesovereign foreign currency rating acts as aconstraint because the project’s ability to acquirethe hard currency needed to service its foreigncurrency debt may be affected by acts or policiesof the government. For example, in times ofeconomic or political stress, or both, thegovernment may intervene in the settlementprocess by impeding commercial conversion ortransfer mechanisms, or by implementingexchange controls. In some rare instances, aproject rating may exceed the sovereign foreigncurrency rating if: the project has foreignownership that is key to its operations; the projectcan earn hard currency by exporting a commoditywith minimal domestic demand, or other risk-mitigating structures exist.

For cross-border deals, however, other forms ofgovernment risk could result in project ratingsbelow the T&C rating. A government couldinterfere with a project by restricting access toproduction inputs, revising royalty and taxregimes, limiting access to export facilities, andother means (see “Ratings Above The Sovereign:Foreign Currency Rating Criteria Update,”published on RatingsDirect on Nov. 3, 2005).

Business and Legal InstitutionalDevelopment RiskEven though a project’s sponsors and its legal andfinancial advisors may have structured a projectto protect against readily-foreseeablecontingencies, risks from certain country-specificfactors may unavoidably place lenders atconcomitant risk. Specifically, risk related to thebusiness and legal institutions needed to enablethe project to operate as intended is an importantfactor. Experience suggests that in some emergingmarkets, vital business and legal institutions maynot exist or may exist only in nascent form.Standard & Poor’s sovereign foreign currencyratings do not necessarily measure thisinstitutional risk or country risk, and so equatingcountry risk with a sovereign’s credit rating mayunderstate the actual risk the project may face(see “Investigating Country Risk And ItsRelationship To Sovereign Ratings In LatinAmerica,” published on April 4, 2007).

In some cases, institutional risk may prevent aproject’s rating from reaching the host country’sforeign currency rating, despite the project’s other



strengths. That many infrastructure projects donot directly generate foreign currency earningsand may not be individually important for thehost’s economy may further underscore the risk.

In certain emerging markets, the concepts ofproperty rights and commercial law may be atodds with investors’ experience. In particular, thenotion of contract-supported debt is often a novelone. There may, for example, be little or no legalbasis for the effective assignment of power-purchase agreements to lenders as collateral, letalone the pledge of a physical plant. Even iflenders can obtain a pledge, it could be difficultfor them to exercise their collateral rights in anyevent. Overall, it is not unusual for legal systemsin developing countries to fail to provide therights and remedies that a project or its creditorstypically require for the enforcement of their interests.

Credit EnhancementSome third parties offer various credit-enhancement products designed to mitigateproject-level, sovereign, and currency risks,among other types. Multilateral agencies, such asthe Multilateral Investment Guarantee Agency, theInternational Finance Corporation, and theOverseas Private Investment Corp. to name a few,offer various insurance programs to cover bothpolitical and commercial risks. Project sponsorscan themselves provide some type of support inmitigation of some risks--a commitment thattends to convert a nonrecourse financing into alimited-recourse financing.

Unlike financial guarantees provided bymonoline insurers, enhancement packagesprovided by multilateral agencies and others aregenerally targeted guarantees and notcomprehensive for reasons of cost or because suchproviders are not chartered to providecomprehensive coverage. These enhancementpackages cover only specified risks and may notpay a claim until after the project sustains a loss.Since they are not guarantees of full and timelypayment on the bonds or notes, S&P needs toevaluate these packages to see if they mayenhance ultimate post-default recovery but notprevent a default. Once a project defaults, delaysand litigation intrinsic in the claims process mayresult in lenders waiting years before receiving a payment.

Therefore, our estimation of the timeliness

associated with the credit-enhancementmechanism is critical in the rating evaluation. ForStandard & Poor’s to give credit value to insurers,the insurer must have a demonstrated history ofpaying claims on a timely basis. Standard &Poor’s financial enhancement rating (FER) for insurers addresses this issue in the case of private insurers.

Outlook For Project FinanceProject finance remains a robust vehicle forfunding all types of infrastructure across theglobe, and its creative financing structurescontinue to attract different classes of both issuersand investors. Project finance continues to be achosen financing technique due to a strong globalpush to add all types of energy and transportationinfrastructure, and to build new or more public-oriented assets, such as stadiums, arenas,hospitals, and schools, just to name a few.

In the Middle East, the continuing developmentof mega-sized, government-driven energy andreal-estate projects is likely to continue for yearsto come. Related investment in shipping to deliverenergy projects from the region is also enormous.

In the U.S., project-finance transactions in thepower sector, both for acquisitions but also fornew gas- and coal-fired plants and a host ofrenewable energies, remain very robust.Additionally, development activity of new nuclearpower plants, some of which are likely to beundertaken on a project-finance basis, is beingstudied. The U.S. market is also noteworthy forlarge investments in natural-gas prepay deals.

In Europe, project investment in rail and airtransportation remains sound, and private-financeinitiative investment in the U.K. continues to berobust. Its cousin, public-private partnershipslending for transportation and socialinfrastructure investments in Australia andCanada, has also strengthened.

These favorable trends offset less-favorabledevelopments in other parts of the world, such asin Latin America, where policies in somecountries (Venezuela, for example), have led tonationalization of some project assets and anunfavorable market for further project funding.

Investor attention to project risk is important,especially in light of the relatively easy lendingcovenants and asset valuations seen in a numberof project transactions in recent years.

Standard & Poor’s expects that project sponsors





and their advisors will continue to develop newproject structures and techniques to mitigate thegrowing list of risks and financing challenges. Asinvestors and sponsors return to emergingmarkets, particularly as infrastructure investmentneeds increase, project debt will remain a keysource of long-term financings. Moreover, as themarch toward privatization and deregulationcontinues in markets, nonrecourse debt will likelycontinue to help fund these changes. Standard &Poor’s framework of project risk analysisanticipates the problems of analyzing these newopportunities, in both capital-debt and bank-loanmarkets. The framework draws on Standard &Poor’s experience in developed and emergingmarkets and in many sectors of the economy.Hence, the framework is broad enough to addressthe risks in most sectors that expect to useproject-finance debt, and to provide investorswith a basis with which to compare and contrastproject risk. ■


OverviewSince the groundbreaking Chicago Skywaytransaction in late 2004 (Skyway ConcessionCompany LLC), Standard & Poor’s RatingsServices has observed rapid growth globally inaccreting debt and swap structures applied toproject finance infrastructure transactions.Infrastructure is one of the hottest asset classes,with private and public pension fund equity andvarious long-term debt providers significantlyfunding long-term concessions or infrastructure-asset purchases.

In some transactions we have observed,accreting debt and swap structures have facilitatedsignificant acquisition premiums (or refinancinggains). This is because accreting debt allows thepartial deferral of interest payments to reducedebt service early in the concession or provides anadditional non-operating source of funds to theproject in the form of payments from an accretingswap early in a concession. The cash flow effectsof a deferral of interest payments or the additionof swap inflows to operating revenue results inoverstated debt service coverage ratios (DSCRs)that, in turn, allow for the tailoring of debtservice to meet a project’s early-year cash flowdeficiency and, in many instances, early outflowsin the form of equity distributions. Without thesestructural features, a highly leveraged project’s netcash flows available to service debt early in theconcession would not meet debt serviceobligations under a traditional amortizing or even interest-only debt service profile.

Simple economics of numerous global capitalpools pursuing a limited number of concessions oracquisition targets results in predictably highvaluation multiples, boosted by financialstructures that front-load dividends and returns toequity while risk for debt holders lies toward theend of a concession. As a result, metrics such asenterprise value-to-EBITDA and debt-to-EBITDA,on a current and pro forma basis, have becomeincreasingly aggressive in a relatively short periodwhile investors still assume these to be investmentgrade structures. Given that business risk has notshifted, this could be a challenging assumption.Moreover, the acquisition multiples areconsiderably higher for many infrastructurefinancings than investment-grade M&Atransactions in other sectors. In the near term, the

recent shift to conservatism in credit sentiment bylenders (as demonstrated by stricter covenantrequirements, tighter loan underwriting standards,less aggressive structures etc.), together with a risein nominal interest rates, could curb the fairlyaggressive debt financing structures observed inmany recent long-term infrastructure concessionsand acquisitions. In the long term, we expectinfrastructure assets to maintain their appealgiven generally solid business positions and abilityto leverage relatively stable cash flows throughlong-dated concessions--permitting long-term debt maturities.

This report follows “Credit FAQ: Assessing TheCredit Quality Of Highly Leveraged Deep-FutureToll-Road Concessions” and “GlobalInfrastructure Assets And Highly LeveragedConcessions Raise New Rating Considerations.”This article expands upon topics addressed in theprevious reports and provides analytical insight toour approach in evaluating accreting debt withinproject finance transactions.

Overall, Standard & Poor’s believes thatinfrastructure financings for long-termconcessions capitalized with accreting debt canachieve investment-grade ratings; however, thereare several key factors that will differentiate--incombination with the assets under consideration--investment-grade structures from those exhibitingspeculative-grade characteristics. In particular, atthe investment-grade level, we place greateremphasis on distribution test multiples, potentialcash lock-ups and sweeps, examining thepercentage of accretion relative to total debt attransaction inception--with little-to-none forshort-term concessions (for example, 20-35years), limits to additional indebtedness, andemphasize the risk/reward allocation betweensponsors and lenders.

Question 1: Does accreting debt increase the probability of default for an infra-structure project?Yes and no. In the early years of an accreting debtstructure, the probability of default is lowercompared with that of a traditional amortizingstructure, as the debt service is artificially low.However, towards the middle and end of theconcession, when higher accreted debt balancesamortize or when bullet payments are due as the


CREDIT FAQ: ACCRETING DEBT OBLIGATIONS ANDTHE ROAD TO INVESTMENT GRADE FORINFRASTRUCTURE CONCESSIONS

Publication Date:

Sept. 5, 2007

Primary Credit Analyst: Paul B Calder, CFA,Toronto, (1) 416-507-2523

Secondary Credit Analysts: Kurt Forsgren, Boston, (1) 617-530-8308

Ian Greer, Melbourne, (61) 3-9631-2032

Lidia Polakovic, London, (44) 20-7176-3985

Additional Contact: Santiago Carniado, Mexico City, (52) 55-5081-4413



risk of refinancing is introduced whileperformance risk can have increased at an evenhigher debt burden. At this point, default riskincreases significantly.

Compared to an amortizing profile--all elsebeing equal, including the proportion of equitycontribution to a project--an accreting debtstructure will have weaker credit quality.Accreting debt establishes a more aggressivefinancial risk profile and defers repayment ofdebt, often well into the future. The longer thedebt repayment profile, the greater the cash flowuncertainty could lead to deterioration in aproject’s financial risk profile, thereby raisingdefault risk. Moreover, accreting debt and swapstructures allow significant early period dividendspaid to equity sponsors (before debt repayment)as a result of the excess cash flow produced bythe accretion or “deferral” component of the debtstructure. This practice and its effect on creditquality are discussed in Question 6.

Even for infrastructure assets with strongbusiness risk profiles, the presence of accretingdebt in the capital structure would temper creditquality. Standard & Poor’s believes that the moreaggressive the financial structure, the less robustthe business risk profile; the weaker the legalprovisions and the greater the contractual riskallocation to the concessionaire, the weaker therating on a long-term concession or infrastructureasset will be. In addition to accreting debt’sinfluence on default probability, characteristics oftransactions that, in the absence of offsettingcredit strengths, are likely to experience weakerdebt ratings, include the following:

• A weaker business risk profile. The importance of the project rationale and business profile to credit quality cannot be understated and is discussed more fully in Question 4;

• A shorter concession term and shorter equity tail;

• Notable construction risk without commensurate offsetting third-party credit supports or cost and schedule risk mitigation strategies;

• Annual increases in debt service payments that significantly exceed those in total project revenues;

• Refinancing risk; • Unhedged currency risk;

• High country risk, including political stability, currency transferability and exchange matters; and,

• Weak swap or transaction counterparties.

Question 2: Why is early return to equity(through cash distributions) a concern?Project ratings address not only the ability butalso the willingness to pay obligations in full andon time. An equity party that had alreadyreceived a full return on an investment early inthe concession would have reduced incentive inresolving issues in times of distress, as preservingthe equity return might no longer be aconsideration. As such, where an equity partyreaped a full return in the early stages of theconcession, Standard & Poor’s would want to beconfident that the sponsors had sufficiently strongincentives to ensure the project would operatesuccessfully throughout the debt’s life. In general,we consider that a more closely aligned interest ofdebt and equity is a project strength.

In addition, the equity participants, throughtheir agents--management--can also makedecisions about timing of capital expenditure andother revenue or profit enhancing measures- suchas toll increases, which could bring forwardreturns at the expense of the project’s viability.

Question 3: In what asset classes have youobserved accreting debt structures?Accreting debt structures arise in volume-driventransactions. The assumption in these transactionsis that an increasing debt level can be absorbed asusage (traffic, tonnage, and containers, forexample) and increases in revenue (tariff/tollincreases) generate higher net cash flows. Assetsthat lack this characteristic will unlikely seeaccreting debt as a long-term funding source.

The breadth of potential infrastructureacquisition and concession interests by privateequity and public pension fund sponsors hasincreased with project finance structuresbecoming more aggressive and complex. Standard& Poor’s has observed a growing universe ofpotential asset classes to which long-termconcessions might apply. Some of those sectorsinclude airports, port and port terminal operators,parking facilities, toll roads and bridges, waterand waste water facilities, lotteries and masstransit projects. Accreting structures are not only


found in project and concession financing but incorporate securitizations of the aforementionedsectors as well.

Question 4: Why is the business risk profile soimportant to the credit quality of infrastructuretransactions that use accreting debt?A project rating is a composite of many factors.To narrow the analysis to two factors--businessand financial risks--some straightforwardobservations can be made. The stronger thebusiness risk profile, the weaker the financial riskprofile (including accreting debt and swaps) canbe to achieve a certain rating, and vice versa. Togauge the appropriate financial risk at investment-grade, the prime focus should be on theunderlying business risk. Accordingly, to assesswhether at investment-grade an accreting debtstructure is commensurate, it is important tounderstand the business risk first, hence theimportance of the business risk to the rating.

As we view accreting debt structures to be moreaggressive, for a similar rating an accretingtransaction would need to have other strengths tocompensate for this credit weakness.

The strong business risk profiles and generallyrobust cash flow streams of infrastructure assets,together with strong covenant packages,compliance with SPE bankruptcy remotenesscriteria, and supportive structural features allowinfrastructure projects to be more highlyleveraged and use accreting debt compared with acorporate entity at the same rating level.

A strong business risk profile for long-termconcessions and infrastructure providers wouldinclude a combination of the followingcharacteristics (the listing below does not implyany ranking of relative importance):

• An essential or high-demand service;• Where user fees are involved, a high degree

of demand inelasticity with respect to rate increases;

• Monopoly or near-monopoly characteristics, or, alternatively, few providers in the industry with substantial barriers to entry and limited incentives for competition among these service providers;

• A limited reliance on increases in volume growth rates (for example, market exposure to traffic, parking activity, tonnage, or maritime containers), and aggressive

assumptions of price inelasticity to rate or tariff increases to meet base case revenue projections;

• A favorable legal environment and regulatory regime;

• Limited government interference probability, either through public policy changes and/or change-in-law risk;

• A favorable rate-setting regime, although we recognize that it is rarely unfettered and, even then, can face challenges or political contention;

• Strong bargaining power in relation to suppliers and customers;

• Low, contained, or manageable ongoing capital expenditure requirements;

• Strong counterparty arrangements with, for example, contractual offtaker agreements or remittance of payments from a highly rated public sector entity;

• Strong historic track record of the asset. To this end, a project that is exposed to greenfield or start-up operations with no usage history (for example, a complete reliance on independent consultant projections) would be considered to have a weaker business risk profile; and

• Proven technology for construction and major maintenance activities, as applicable.

Question 5: Do you differentiate between the forms of debt increase in an infra-structure transaction?In our credit evaluation of long-term concessions,we attempt to understand the economic substanceand evolving profile of the debt structure: its riseand repayments over time relative to the businessrisk profile of the project and the term of theconcession. The project debt balance couldincrease based on a contractually agreed toschedule. Alternatively, the debt balance couldvary based on required cash flows procured froman alternate financing source to meet debt servicerequirements and equity distribution targets.Finally, the project debt could rise due to a directcontractual link to an inflation index thatincreases during the term of the debt.

Standard & Poor’s has observed several formsof debt instruments that can cause a project’s debtto increase early in a concession and result inoverstated traditional DSCRs. For comparative



purposes, Standard & Poor’s will also calculate anadjusted DSCR assuming the accretion is a debtservice cash flow item (see Question 10). Types ofinstruments in which debt could rise include:

• Capital Appreciation Bonds (CABs)--These are debt instruments where a portion of the interest due and payable to the creditor is deferred and added (capitalized) to the principal balance according to an agreed debt service schedule between the borrower and lender.

• Accreting swaps--These can be used alongside a conventional debt instrument to create the same economic effect as CABs. As the accreting swap counterparty is a debt provider, we expect that the accreting swap will be considered pari passu with senior debt obligations under the project financing documents. Although there could be variations on accreting swap use, one form uses a floating-rate (e.g. LIBOR-based) loan. In this case, the project enters into an interest rate swap to convert the floating rate exposure to a fixed basis. Part of the interest obligation on the project’s fixed-rate payment to the swap counterparty is deferred and capitalized with the swap principal balance to create the accreting structure. The floating-rate payments from the swap counterparty meet the project’s floating (LIBOR) based obligations originally incurred. This synthetically creates the CAB structure described in the first bullet.

• Accreting swap with embedded loan--In this instance, the swap payment from the counterparty is a cash inflow for the project rather than an interest payment deferral and floating rate pass-through as noted in the second bullet.

• Credit facilities--Ostensibly the same as thethird bullet, a credit facility can be used to create the same economic effect as the accreting swap (an embedded loan). The credit facility can provide cash flow to a project in the early years of a concession, bridging debt service obligations that may be higher than cash flow available. The draws can also provide cash flow funding for equity distributions early in the concession. Similar to an embedded loan, this form of financing would likely also rank pari passu

with project senior debt.• Inflation-indexed securities--Treasury

inflation protected securities (TIPS) in the U.S.; capital indexing bonds in Australia; indexed linked notes in the U.K.; inflation units in Mexico; and real return bonds in Canada are examples of securities that see the principal payment or principal balance (if it is a bullet maturity instrument) and coupon payment adjusted upward based on changes in an inflation index (such as the consumer price index). Projects with revenue streams or rate increase mechanisms strongly linked to inflation benchmarks typically issue these securities. The weaker the revenue link to inflation, the greater the potential deterioration in DSCRs due to a mismatch over time between cash flow available to service debt and the project’s debt service obligations.

Whether the accreting swap payment isincluded as income (or a credit facility is providedto the project as an inflow) or a projectcompany’s debt and swap repayment scheduleallows the partial deferral of interest payments(understating debt service), the economic effect isthe same. DSCRs are overstated and lesscomparable with DSCRs in more traditionalamortizing debt structures.

While the form of the project debt increase andits subsequent repayment profile is important, sotoo is the absolute size of the debt increaserelative to the original debt issuance attransaction inception. This is discussed inQuestion 7.

Question 6: What are the observable effects ofaccreting debt on a transaction and its potentialcredit quality? The primary effects relate to imposing aggressivefinancial structures on the asset dependent onlong-term revenue growth. In particular, we notethe following compared with traditionalamortizing or many bullet structures associatedwith infrastructure financings:

• Growing debt levels. Unlike a conventional debt refinancing for a volume risk asset (which typically occurs when construction has been completed and/or a usage history is known), accreting debt or an accreting swap crystallizes the future debt burden before the



project economics and expected revenue growth are known. Unless revenue and EBITDA growth is at least equal to the proportion of debt accretion, DSCRs will narrow and the enterprise value of the project will decline.

• Greater reliance on growth. Accreting debt structures cause an overstatement of DSCRs in the early years of a concession (by the amount of the interest accrual or swap inflow to the project). This allows early-year cash flow deficiency to be managed (relative to expected net revenue) while maintaining dividend payments. Moreover, to the extent the revenue, EBITDA, operating, and capitalcost and refinancing assumptions are aggressive, as the accreting debt balance amortizes in the medium-to-long term, long-term DSCRs are at risk of not meeting base case projections.

• Increased flexibility. Deferred-pay mechanisms and non-amortizing structures can inject flexibility into an infrastructure financing structure, especially under more aggressive revenue growth assumptions or during the project’s start-up phase. However, these deferability features introduce additional credit risks for senior lenders as debt increases.

• Allocation of risk/reward altered. Significant dividend distributions remitted as a result of the accreting structure’s deferral of senior debt payments effectively puts equity ahead of debt in the payment structure. This is a reversal of the traditional role of capital structure priority and funds flow subordination, whereby equity acts as patient capital and a buffer for senior debt during periods of revenue ramp-up or project cash flow weakness and is not seen as earning a notable proportion of its projected return ahead of senior debt.

Sponsors have advocated accreting debtstructures by highlighting lengthy concessionterms of many infrastructure transactions thatprovide ample time in later years to repay higherdebt, although that same opportunity to earn cashflow returns later in the concession also applies toequity distributions. Nonetheless, combined withsolid business positions and inflation-linkedrevenues streams, sponsors view the risk profile of

these assets as low. In many respects, long-term concessions can be

viewed as corporate transactions (perpetualeconomic ownership of an asset). Generally,corporate entities debt-finance and refinance onan ongoing basis. For projects, we assume thatfinite debt is issued and repaid along thedepreciating asset life. Also, the benefit ofcovenants in rating corporate type structures isless so than for projects. While the sponsorargument of more corporate style financing ofvery long-term concessions is reasonable, therating challenge is that transaction participantscannot have both the benefit of undertaking acorporate-style financing but calling it a projectfinancing by adding structural features that haveless value in a corporate finance rating approach.

To the extent that a good portion of equityreturns in the early years of a concession isderived from excess cash flow that accreting debtor swap structures produce, rather thanoutperformance by the project, there are clearbenefits and incentives for sponsors to promotefinancing structures that use accreting debt.Standard & Poor’s has observed financial modelsfor infrastructure transactions in which aggressivegrowth assumptions for revenue, together withthe cash flow benefits of using accreting debt (oraccreting swaps), results in the original paid-inequity capital being returned to sponsors beforeany debt repayment occurs. This has appeal toproject sponsors but a fundamental credit issue ishow the shift in risk to long-term lenders and the enhanced returns to equity sponsors affectcredit quality.

Equity risk premiums (the difference between aproject’s cost of debt and its expected equityreturn) can provide a quantitative proxy for therelative risk of an entity. The equity riskpremiums observed for accreting debt structuresin infrastructure financings have been as high as8%-12% (800-1,200 basis points). This reflectsonly pretax cash equity yields and excludesadditional equity return benefit that might beearned by sponsors through tax deductibility ofinterest expense and amortization items (capitalcost allowance deductions or amortization ofgoodwill) should economic ownership and taxbenefits be conferred to the concessionaire due tothe concession’s lengthy term. In contrast,regulated utilities, which we rate slightly higherthan low investment-grade infrastructure projects



with accreting debt, see equity risk premiumsabove their cost of debt of 300-400 basis points.

A traditional risk-reward relationship betweenequity and debt capital providers includes equitycapital taking more of a project’s cash flow risks(such as later-period uncertainty) than seniorcreditors given the significant risk premium thatthe project sponsors can earn. The expectation ofhigher equity returns than fixed-rate debt shouldincorporate the achievement of base case financialprojections and reflect higher risk incurrence bysponsors, thus providing incentive for equity totake a longer view and keep “skin-in-the-game.”As noted earlier, to the extent a large proportionof the value is derived in the early years of theconcession through accreting instruments, suchincentives might be reduced and the interests of equity or sponsors and lenders are not as closely aligned.

Question 7: How do we analyze peak debtaccretion and subsequent amortization guidelinesfor long-term concessions? In analyzing transaction structures for matureassets that have used accreting debt or swaps,Standard & Poor’s has set out broad principles asto how far into the concession debt can rise; whenwe would expect a certain proportion of themaximum accreted debt balance to paid down;and when we would expect final maturity (100%paydown of the maximum accreted debt balance).This amortization principle has varied dependingupon the concession’s length, the asset’s businessrisk profile, and offsetting structural features that might provide support to the credit risks ofdebt accretion.

We are likely to view shorter term concessions(e.g. 20-35 year terms) with short-to-no tail orconcessions with significant construction risk, forexample, as more speculative unless their debtburden and accretion proportion is considerablylower than an asset with a longer concessionterm, all else being equal. In many cases, a short-term concession is not likely to exhibit thecharacteristics that allow for accreting debt andstill achieve investment grade.

We have not previously commented on themagnitude of maximum debt accretion relative tothe original debt at transaction inception. Thiswill be a function of different asset classes,business profiles, structural protections, and

desired rating levels. Our credit analysis alsofocuses on the physical and economically usefullife of an infrastructure asset to which to linkamortization and the final maturity of debt(particularly if the asset risks physical oreconomic obsolescence, substitution, or increasingcompetition). For this reason, there are no fixedstandards for acceptable investment-gradeleverage levels, credit ratios, or debt accretion andsubsequent amortization guidelines. We assesseach credit independently on all these factors,although broad business risk profile distinctionsreflect the strength of certain asset classes and theability to support relative accreting debt burdens.For example, a long-term airport concession, allelse being equal, would likely be considered tohave a stronger business position than a parkingfacility concession, which is likely to have greatercompetition and substitution risks.

Principal OutstandingThe chart above illustrates project debt accretionproportion and subsequent principal amortizationunder three different payment profiles. The linesin the graph do not represent any specific projectthat Standard & Poor’s rates, but illustrates thepotentially different risk profile of varying debt and maturity structures, as well as theimpact the concession term length might have on credit quality.

• The curve at the bottom of the table represents a traditional 25-year amortizing debt instrument common in the U.S. public


© Standard & Poor’s 2007.

0.5

1.0

1.5

2.0

2.5

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

2055

2060

2065

2070

25-year amortizing debt Moderate accreting debt Significantly accreting debt

(x)

0

Debt Structure And Deferred Pay


finance market that has a predominately interest-only payment profile in the first few years of the concession with full amortization occurring thereafter. This amortization schedule may be used to produce level annual debt service costs or, in concert with a capitalized interest period, to manage construction of an asset--for which there could be no revenue receipt until completion. Such a structure might have a modest (to no) equity tail based on a shorter concession.

• The middle curve represents a long-term concession (a term of at least 50 years if there is no equity tail but up to 75 years if there is a 25-year tail). In this senior debt repayment profile, debt accretes to about 25% higher than the original par issuance at or about year 20 and amortizes to zero in the next 30 years.

• The top curve represents a concession that is likely at least 75 years in term, as the senior debt accretes to more than 2x (100%) relative to original par issuance in the first 40 years of the concession and then amortizes rapidly in the next 15-20 years.

Assuming the same asset and business riskprofiles and debt-to-capital ratio at transactioninception, with the notable potential differencesbeing variations in concession term, covenants,legal provisions, and debt and maturity structure,Standard & Poor’s would likely view the firstcurve (colored light green) as the mostconservative financial risk profile and the third(red) as the most aggressive. This is the case giventhe absence of accretion and the proportion ofdebt repayment early in the concession for thefirst scenario and the very high proportion ofaccretion and the back-ended nature of therepayment profile for the third scenario, whichwould also likely imply high dividends payable tosponsors during the period of considerableaccretion. Standard & Poor’s would not view thethird scenario as investment-grade regardless ofhow strong the business risk profile or underlyingasset quality. The second curve (dark green) couldbe investment grade if it had a solid business riskprofile, supportive covenants and legal provisions,and a lengthier equity tail--although how closethis scenario could get to the credit quality of the

first one would be determined by the relativedifferences of these factors.

In summary, our ratings will incorporate themaximum accretion relative to original par debtissuance, the proportion of back-ended principalrepayments and the share of paid-in equity capitalreturned in the form of dividends referenced inQuestions 5 and 6 into our analysis with lessaggressive structures generally associated withhigher rated concessions.

Question 8: How would Standard & Poor’sanalyze the accretion characteristics andsubsequent amortization guidelines for publicinfrastructure owners and debt issuers?These transactions will be evaluated on a case-by-case basis. In the U.S. public finance market,capital appreciation bonds have been employedfor many years, often in the start-up toll roadsector. Although these structures provide cushionand flexibility during the initial years of tollprojects when revenues are still growing, they infact result in a higher debt burden in later years.This can be problematic for a start-up facility,especially during a restructuring, if net tollrevenues fall short of projections and debt servicerequirements. All things being equal, the ability ofa public sector entity to assume accreting debtstructures is comparatively better than forprojects for several reasons including the ability topledge revenues from a variety of assets (not justa single project), the lack of a concession term, itslong-term interests as the permanent asset ownerand the lack of dividend payouts whichpresumably allows for better liquidity and capitalexpenditures that improve asset quality andenhance revenues. As such, adherence to ouramortization guidelines is not necessary forconsideration of investment grade structures.However, on a relative basis, the financial riskprofile of a public sector debt issuer would beviewed as more aggressive and highly leveragedand a weaker credit compared to traditionalamortizing debt structures. Additionally, the samefundamental credit concerns regarding shiftinglong-term risks to lenders exist, although they canbe mitigated through the mechanisms discussed inthis FAQ including cash sweeps and debtreduction under scenarios when revenueprojections fall short of forecasts.



Question 9: Do you review ratios and financingassumptions differently when reviewing accretingdebt structures?No. In addition to ratios and cash flows weexamine the capital structure and liquidity as partof the financial analysis. Our approach to theanalysis of ratios and financing assumptionsplaces emphasis on:

• The magnitude of the accretion in the concession’s early years along with the schedule and pace of debt repayment;

• Distribution policy based on the accreting debt or swap structure;

• Capital (debt-to-total capital) and debt structure;

• Financing rates, including estimated credit spreads on risk-free reference rates and swap rates;

• Refinancing risk, including market risk for refinanced debt and any exposure to changing interest rates and credit spreads at refunding dates;

• Inflation expectations and linkage to revenue setting ability;

• Volume growth estimates for the assets;• Revenue projections and assumed growth

rates--in particular, for proposed toll- or user-rate increases and the modeled demand elasticity associated with such increases;

• Capital expenditure obligations; • The relationship between the growth in

annual debt service costs for the project and the projected growth in revenue; and

• Operating cost assumptions and forecast synergies or savings through a long-term concession respecting a formerly publicly managed asset.

We believe that the private management of aformerly publicly managed infrastructure assetcould present revenue optimization and cost-saving opportunities that might not havehistorically been a priority for a public sectorbody that managed operations with rateaffordability and a break-even financial positionas strategic goals. Public infrastructure owners arecurrently reevaluating this approach to ratesetting in the face of growing capital andmaintenance needs, in addition to other fiscalpressures. Nevertheless, despite the financial

incentives inherent in an entity with equitysponsors, we consider the reasonableness of the financing and operating assumptions in our analysis.

Tightly defined and higher permitteddistribution tests (DSCR based equity lock-ups)provide some measure of protection for dividenddistributions to equity ahead of debt. As part offuture accreting debt transactions, Standard &Poor’s expects more aggressive structures willlikely necessitate some form of debt repaymentthrough a partial cash sweep mechanism fundedfrom locked up equity proceeds. This provisionwould be linked to a period of time in which thepermitted distribution test has been invoked andlocked-up cash proceeds can be redirected fordebt repayment. This provides additionalincentive to sponsors to avoid equity lock-up allaltogether, but particularly for a prolongedperiod, as it might significantly reduce their equityreturn by the amount of trapped cash that mightbe permanently redirected to debt reductionthrough mandatory prepayments.

For investment-grade ratings, Standard &Poor’s also expects to see an alignment betweencash flows allocated to a project’s equity sponsorsand its long-term lenders. Among the ratios thatwe will analyze to guide our approach to betterbalancing cash flow returns between debt andequity is a dividends payable to EBITDA measurethat more closely follows the metrics observed byregulated utilities or other infrastructurecompanies. Regulated utilities have dividendspayable to EBITDA ratios of 15%-25%, whereasa credit such as 407 International Inc. (a 99-yearCanadian toll road concession company) hasposted dividend-to-EBITDA ratios in the mid-to-high 20% range. For many of the accreting debtconcession transactions that we observe, this ratiois considerably higher because of debt accretionand swaps.

Standard & Poor’s is reviewing using debt stockratios (such as debt to EBITDA) and cashdistribution measures (such as annual dividenddistributions relative to annual project EBITDA)to complement DSCRs, traditional credit metrics,and stress testing scenarios. These ratios will playan increasing role in investment-grade creditmetrics for infrastructure concession projects thatuse accreting debt structures.



Question 10: If traditional DSCRs are lessmeaningful, how do other measures such as LoanLife Coverage Ratios (LLCR) or Project LifeCoverage Ratios (PLCR) factor into the analysis?Traditional DSCRs are of limited analytical valuewhen a financial risk profile has significantaccreting debt or accreting swaps because the cashflow effects (deferral of interest or non-operational inflows) to the project early in theconcession term overstates this ratio. To this end,we estimate the project’s cash flow based DSCR(including the effects of accreting debt oraccreting swaps) but also calculate a DSCRprofile that would adjust for the effects ofaccretion and debt capitalization. This is ofparticular value in the review of the early years ofa concession, when accretion features tailor debtrepayment to revenue growth assumptions.

In calculating an alternative DSCR, we includein the denominator the project’s actual cash-basedpayment of debt and swap obligations, as well asthe capitalized amount that is deferred and addedto the project’s debt balance. For certain kinds ofaccreting swap structures, the adjustment removesfrom the numerator swap inflows payable to theproject that achieve the same effect as the interestpayment deferral. This adjusted DSCR calculationcomplements the review of the percent rise in debt(due to accretion) that occurs from the originalissuance to the project’s maximum peak debtbalance (including accrued swap amounts owing).

In calculating the base case DSCRs for accretingdebt projects, we include in the numeratoroperating revenue (excluding interest income,earnings from asset sales, debt or equity proceeds,and insurance proceeds) minus operating andmaintenance expenses (including mandatorymajor maintenance reserve account deposits). TheDSCR numerator can also exclude swappayments to the project from the swapcounterparty if these payments are viewed as apass-through to meet the project company’sobligation to a debt provider. Drawdowns on anLOC or accreting swap proceeds that achieve thesame effect as an interest payment deferral can bean adjustment to the DSCR numerator given theirprimary cash flow structuring role. In addition totraditional cash interest obligations, whichdeferral features will understate, the DSCR

denominator includes any monoline bondinsurance costs and swap costs associated withsynthetic debt products.

LLCRs and PLCRs are less relevant to debtratings, which assess an issuer or debt issue’sprobability of default; however, these ratiosprovide important analytical value to ourrecovery rating process, in which we assess therecovery of accrued interest and principaloutstanding following an unremedied paymentdefault. In addition to being based on projectedrevenues, LLCRs and PLCRs are generally higherthan DSCRs, which typically reflects the equitytail at the end of the concession (when the projectdebt has been retired.)

During cash flow weakness, LLCRs and PLCRscan remain well above 1.0x, whereas periodicDSCRs during the same time frame could fallbelow 1.0x, requiring draws on liquidity to avoiddefault. A project could default on its debtobligations, while depending on assumptions ofcapital structure, discount rate, and revenuegrowth following the default for the remainder ofthe concession, the LLCRs and PLCRs (a proxyfor recovery) could be greater than 1.0x (orgreater than 100% recovery). For projects withmanageable peak accretion and a considerableequity tail, such a solid recovery scenario is quite possible.

Question 11: Can security features and structureand protective covenants offset the relative higherrisks of an accreting debt structure?Protective covenants can strengthen atransaction’s credit profile by limiting the abilityof the project to incur more debt, acquire dilutivebusinesses or distribute cash when it performsbelow base case expectations. No amount ofstructuring or covenant protection, however, cancompletely compensate for a weak business riskprofile or overly aggressive financial structure.

Standard & Poor’s expects the standardstructural features or covenants to be consideredfor a project rating, particularly one thatincorporates accreting debt and has a moreaggressive financial profile. Where covenantsrequire quantitative limits (such as DSCR basedtests), there is no fixed rule of thumb that can beapplied to achieve an investment grade rating.



Question 12: Is the documentary and legalreview for an accreting debt or swap structuredifferent from other project finance or PPP ratings? No. The legal review across project structures iscomparable, and Standard & Poor’s expects thattransactions using accreting debt will have arobust legal structure. Our documentation andlegal review includes a detailed examination ofthe concession agreement terms, and itssupporting schedules and appendices, whichgovern the long-term relationship and riskallocation between the concessionaire and the concession grantor. Standard & Poor’s legal review will also examine any proposedintercreditor agreement and the covenant package.

Certain jurisdictions benefit from more creditor-friendly legal regimes that can contribute toinfrastructure project rating differences.Infrastructure project financings are generallymore susceptible to local law exposure than othertypes of structured financing because of thephysical location of the assets and the oftenessential and politically sensitive nature of theassets. For more information, see “JurisdictionMatters For Secured Creditors In Insolvency” and“Emerging Market Infrastructure: How ShiftingRules Can Stymie Private Equity.”

Question 13: Beyond the already stated effects ofaccretion, how does Standard & Poor’s evaluateswap transactions as part of its credit analysis?Many project sponsors employ interest rate orcurrency swap strategies to achieve cost-effectivedebt financing. These swaps are generallyintegrated into an overall swap that includesaccretion features.

A capital structure that includes both debt andaccreting swaps will require a review of therelevant swap documentation and inter-creditoragreement. As an accreting swap counterparty isallowing a portion of the project company’sinterest payable under its swap arrangement toaccrue, it is acting as debt provider, and theseswap obligations will likely be considered paripassu with other debt obligations. It is importantto determine if there are cross default provisionson events, such as early swap termination, whichcould lead to acceleration of the debt obligations.

One potential credit issue is whether or not the

transaction is swap-independent. For example, ifthe swap were to terminate, the issuer would payor receive a payment to or from the swapcounterparty. If the issuer did not receive apayment due to a counterparty default, it mightnot be able to replace its swap position at similarrates or terms, so might not be able to perform at previously expected (rated) coveragelevels without rate increases or possible rating implications.

For transactions originating in the U.S. withU.S. swap counterparties, Standard & Poor’smight undertake a debt derivative profile (DDP)exercise. Although we consider many factors, theDDP scores principally indicate an issuer’spotential financial loss from over-the-counter debtderivatives (swaps, caps, and collars) due tocollateralization of a transaction or, worse, earlytermination resulting from credit or economicreasons. We integrate DDPs into rating analysesfor swap-independent issuers, and they are one ofmany financial rating factors.

These credit issues are central to our ratinganalysis as monoline bond insurance policiesmight guarantee swap payments due from (butnot due to) the issuer. As a highly rated financialguaranty policy should maintain payments to theswap counterparty (should a wrapped project notbe able to meet its swap and debt obligations dueto poor performance), the project companyshould not be in default on its side of the swap.Swap renewal, if applicable, and swapcounterparty credit quality remain analyticalissues, even for monoline wrapped transactions.As a result, Standard & Poor’s will examinewithin a swap transaction the level and minimumcredit quality of collateral posting, andreplacement requirements should minimum creditrating levels be violated by swap counterparties.

Question 14: Given the commitments ofmonoline bond insurers, how is refinancing riskfactored into the credit rating for an accretingdebt structure?A monoline insurer that provides a guaranteepolicy for refinancings reduces the market accessrisk and the spread risk at refinance. Even ‘AAA’interest rates and credit spreads vary and in theabsence of a hedging strategy, the uncertain futurecost of debt refunding could narrow coverageratios in a stress case. We evaluate the underlying



credit quality of a transaction before overlayingand assessing the incremental contribution ofcredit substitutions such as monoline wraps.Moreover, our view of refinancing risk depends inlarge part on the expected cash flows of theproject at the time of refinancing.

Our starting point is to assume that refinancingrisk within an accreting debt structure ismanageable in long-dated concessions with asufficient tail (about 10-30 years). We willexamine financial models to understand theassumptions being made about refinancing (suchas the interest rate employed) and stress tests willbe used to evaluate the sensitivity of transactionsto less-favorable interest rate assumptions atrefinancing points. The history, record andexpectation of local debt markets will have adifferent weight on emerging markets. Investment-grade structures will typically havesecured appropriate hedging arrangements in thisregard. A monoline insurer’s commitment simplygives additional comfort to any refinancing risk analysis. ■


Emboldened by active competition andcontinued demand for project andinfrastructure assets, the landscape for

subordinated debt structures in project financetransactions continues to evolve. Indeed, somedebt arrangers are pushing new boundaries tostructure and fund ambitious greenfield andbrownfield asset developments or leveragedacquisitions (see “The Changing Face OfInfrastructure Finance: Beware The AcquisitionHybrid” on page 8). Notwithstanding the recentupheaval in credit markets, the driving forcebehind debt structuring is usually simple: lowerthe after-tax weighted-average cost of capitalwhile providing flexibility to project sponsors andinvestors and enhancing cash returns on equity.The result is most often higher leverage andadded complexity through a mix of senior andsubordinated debt--more eloquently referred to as“structural optimization” by debt arrangers.

As employed in project finance for many years,market participants are “tranching” a project’sliability structure into senior debt, subordinateddebt, and in more recent years--depending on thewindow of opportunity--“payment in kind” (PIK)notes (see “LBO Equity Hybrids: Too Good To BeTrue” published on RatingsDirect on Aug. 10,2007). Importantly from a credit perspective,regardless of the underlying project, the commontheme is increased gearing and more complexfunding and documentation structures--bothwhich have varying effects on a project’s debtratings and recovery prospects in terms of thepotential level of default and loss given default.

This FAQ will highlight the criteria issuesrelated to analyzing senior and subordinatedstructures in the context of issue ratings andrecovery analysis.

Frequently Asked QuestionsWhat is project subordinated debt?In its purist and simplest form, a project’ssubordinated debt typically ranks behind aproject’s senior debt in terms of priority over pre-default cash flows and security over collateral,and in the event of insolvency behind anyenforcement proceeds, assuming there is anythingleft. In this context, project subordinated debt isused in structures as a form of creditenhancement for senior debt that establishes thedistribution of a project’s default and recoveryover the life of the financing structure.

Typically, the rights for project subordinateddebt are defined under a project’s structural,contractual, and legal framework. This structuralframework for projects should incorporate a“ring-fenced” entity, a pre-default cash-flowwaterfall, cash lock-up and sweep triggers, a debt-service reserve account, and post-defaultliquidation processes. Consequently, given thevarying characteristics of subordinated debt thedefault and loss given default of any tranches ofproject subordinated debt may occur at differenttime intervals over the term of a transaction’s life cycle.

Why is subordinated debt used in project transactions?Subordination gives project finance transactionsthe ability to create one or more classes of debt,which can allow access to more debt or alternateinvestor classes. One of the main objectives ofusing subordinated debt is to improve a project’safter-tax weighted-average cost of capital throughimproving the rating on senior debt whilesegregating credit risk and enhancing the returnon equity. At the same time, sponsors of a projectoften use subordinated debt for tax andaccounting reasons, particularly where there maybe restrictions in distributing cash from a special-purpose-vehicle structure due to retainedaccounting losses. Subordinated debt may also bean option explored by debt arrangers if senior-secured financing options have be exhausted orcapped out.

Can subordinated debt be treated as equity foranalytical purposes?Often project sponsors use subordinated debt as asubstitute for equity. Depending on the underlyingproject ring-fence structure, security, contractual,and legal framework in each jurisdiction,Standard & Poor’s may consider treatingsubordinated debt as equity for analyticalpurposes on a case-by-case analysis. Such ananalytical scenario may occur if a project’s debt: isdeeply subordinated within a strongly ring-fencedvehicle with a structural waterfall and distributiontriggers; has no rights to call default or acceleratepayment; ranks after senior debt under pre-default and post-default cash-flow waterfalls; andmatures after senior debt. Like most financingstructures, however, the answer will reside in thedetail of a particular transaction in its relevantjurisdiction.



CREDIT FAQ: THE EVOLVING LANDSCAPE FORSUBORDINATED DEBT IN PROJECT FINANCE

Publication Date:

Sept. 19, 2007

Primary Credit Analyst: Andrew Palmer, Melbourne, (61) 3-9631-2052

Kurt Forsgren, Boston, (1) 617-530-8308

Terry A Pratt, New York, (1) 212-438-2080

Secondary Credit Analysts: Paul B Calder, CFA, Toronto, (1) 416-507-2523


Santiago Carniado, Mexico City, (52) 55-5081-4413

What are some of the key types of projectsubordinated debt?While there are project-specific nuances, in mostinstances the type and level of subordinated debthas been tailored to the cash-flow characteristicsof each project. Standard & Poor’s has identifieda variety of structural, contractual, and legalforms of subordinated debt in project financetransactions:

Deeply subordinated (pre- and post-default) debt. A form of deeply subordinated debt is shareholderloans, which display many of the characteristicsof equity, and have no rights to call default orrights on enforcement, or calls on the post-defaultrecovery proceeds. This form of subordinateddebt is often used in the public-private-partnership (PPP) space as tax-efficient equity for sponsors.

Residual value subordinated debt. This debt is structurally reliant on residual ordividend cash flow from another project-financedvehicle with senior-ranking debt and possibly evensubordinated debt obligations. These residual cashflows or dividends are usually only availablesubject to certain debt lock-up tests beingachieved at the underlying project funding vehicle.Dividends or residual flows may also bedependent on the ability of a project company todistribute cash flows due to retained accounting losses.

PIK notes. Typically, PIK notes are structurally subordinatedto senior debt or second-ranking lien debt in aproject’s pre-default and post-default cash-flowwaterfall, with coupon payments at the discretionof the issuer. If coupon payments under the PIKnotes are not made in the form of cashdistributions, the coupon is usually made wholeby the issuance of PIK notes of equivalent value.Unlike true equity, PIK notes usually have amaturity date and at least some rights against theissuer to help ensure repayment. Standard &Poor’s will treat PIK notes as debt in calculatingcredit metrics.

While it may be possible to carve-up a project’scash flows to create a subordinated instrument ina number of forms, there is no “free lunch”, andat some point the key consideration is how asubordinated debt instrument will or will not

affect default or recovery of senior-ranking debtfrom a credit and legal perspective.

What are the key structural elements consideredby Standard & Poor’s?In examining a project’s liability and capitalstructure, we are often asked what the mainstructural and documentation considerations itundertakes to assess how a project’s debt isstructurally, contractually, or legally subordinated.The objective is relatively simple: if subordinateddebt obligations are to provide credit support andcollateral to senior rated debt, then subordinateddebt must have no rights that could accelerate orcause default or increase the level of loss givendefault of any senior-ranking debt. Nevertheless,Standard & Poor’s will typically review severalaspects in any assessment:

The rights of subordinated debt to call a defaultor cross default to senior classes of debt. It is not appropriate that a payment default on atranche of subordinated debt could cause adefault under the senior debt provisions.

The rights of subordinated debt to acceleratepayment while senior debt is outstanding. Subordinated debt should not have any right toaccelerate while senior debt is outstanding.

Senior debt rights to lock-up or sweep cash flow. Following any breach of a senior debt cash-flowlock-up trigger or cash-flow sweep trigger,subordinated debt should not be entitled to anycash flow, other than what might be availablefrom reserves that are specifically dedicated to thesubordinated debt obligations. Similar to thepoint above, this should also not givesubordinated debt any rights to call or triggerdefault or acceleration as a result of a senior lock-up or sweep trigger being breached.

The pre-default and post-default cash-flowwaterfall and transaction documentation. This is necessary to understand how subordinateddebt is structurally and legally subordinated. Thiswould include an understanding of how cashflows are distributed and shared in a transaction’scash-flow waterfall. Typically, subordinated debtshould be serviced after payments to operations,senior debt interest and principal, any net hedgingsettlements, and any senior debt-service reserves




and maintenance accounts, which are there tosupport the senior debt rating. Likewise, collateralsecurity interests or claims upon liquidation granted to subordinate lenders should rank aftersenior debt.

The maturity profile of subordinated debtshould be longer dated than senior debt,otherwise it is not truly subordinated.

The voting rights of debt participants. These rights should be limited solely to seniordebt participants; subordinated debt should haveno rights while senior debt is outstanding.

Nonpetition language. This needs to be considered to ensure that nowinding-up provisions are allowed while seniordebt is outstanding either permanently or for aspecified period. Typically, the objective is toensure that subordinated debt has no right tochallenge any enforcement rights or validity in thepriority of payments of senior debt holders.

The events of default and termination events of any interest-rate swaps used to hedgesubordinated debt. These need to be closely examined. Although themajority of subordinated debt is fixed-rate debt, ifvariable subordinated debt is used and overlaidand mitigated with a interest-rate hedge, theevents of default and termination events of theswap would need to be limited so as not toaccelerate or cross-default senior debt.

Subordinated debt rights or remedies in arestructuring, insolvency, or bankruptcy proceeding. Deeply subordinated debt should not have anysuch rights or remedies. For beneficial equitytreatment, project subordinated debt should onlybe able to enforce its security and creditor rightsunless, and until, senior debt has done so.

What is the analytical framework for projectsubordinated debt?Some market participants think of the analyticalassessment behind rating subordinated debt asone of simply solving a target debt-service coverratio (DSCR) or simply notching off the seniordebt issue rating. But our approach is moresophisticated. No two projects are the same from

a business, industry, market, operational,structural, or legal perspective. Certainly, it is fairto say that a senior debt issue rating providessome starting point for the subordinated debtrating. However, in order to make a properassessment, we assess a project’s cash flows tounderstand where the credit stress points may berelative to the payment structure under thesubordinated debt instrument and its exposurehorizon. In assessing the ability and willingness ofa project’s subordinated debt to pay itsobligations in full and on time, our analyticalframework reviews and measures a number ofelements that influence the level of potentialdefault and rating of a subordinated debt tranche:

The underlying business and industry risk of a project.This examines the key business and industryeconomic fundamentals that influence theunderlying volatility of a project’s operating cashflow.

A project’s financial ratios (for example, DSCRon a total debt basis {senior and subordinateddebt} and segregated subordinated debt basis after{senior debt}). It is important to note that theDSCR should not be viewed in isolation. This isparticularly true when a project includes accretingdebt structures that can overstate a transaction’sDSCR, while also deferring senior debtamortization. (see “Accreting Debt ObligationsAnd The Road To Investment Grade ForInfrastructure Concessions” on page 105). As aresult, we closely examine all financial ratios,particularly revenue growth assumptions and thecomponents of the coverage ratios that are can beoverstated by such financing instruments.

Senior debt cash lock-up triggers, sweep triggers,and reserve limits (for example, senior debt-service reserve and maintenance reserves).Understanding these triggers and reserves is acritical part of the analytical framework forsubordinated debt, as such lock-up triggers andreserves are for the protection of senior lendersonly, and may result in subordinated debt beingmore susceptible to default, particularly ifsubordinated debt does not have its owndedicated debt-service or liquidity reserve.


Sensitivity and break-even analysis on eachproject is undertaken. This takes into account the specific cash-flowwaterfall structure and repayment terms andconditions of senior and subordinated debt.Sensitivity analysis helps demonstrate andhighlight potential downside thresholds underwhich subordinated debt may miss a payment ofinterest or principal. Stress tests, which areusually in the form of break-even analysis, assistin understanding whether a missed payment isdue to any lock-up triggers or other distributionstoppers being breached and stopping cashflowing through to subordinated debt (and anydedicated debt-service reserve running out), orjust the fact that there is not enough cash afterthe senior debt has been serviced irrespective ofany distribution trap or stopper. Stress sensitivitiesare run on revenues, availability, prices, operatingcosts, capital expenditure, inflation, andrefinancing spreads. Typically, the level of stressplaced on subordinated debt is reconciled with theoverall risk of the project and likelihood of astress scenario occurring.

Assessing the level and type of creditenhancement supporting subordinated debt. Such credit enhancement can take the form ofequity, and project cash flows available aftersenior debt-service and liquidity reserves, usuallyin the form of dedicated debt-service reserves forthe benefit of subordinated debt. If asubordinated debt instrument does not have itsown debt-service reserve, it is likely to be moresusceptible to default under stressed scenarios.

Ability for senior debt to raise additional debt oroffer security ahead of subordinated debt. Most projects allow limited other financialindebtedness to be raised and security granted toenhance the rating of senior debt. However, if thisright is too broad, it may affect the level ofsubordination, which may change over time.

What will influence the probability of default onsubordinated debt?Apart from a project’s underlying operating andbusiness fundamentals, which will be the majorinfluence on the performance of a project, theprobability of default of a project’s subordinateddebt will be influenced typically by:

• The contractual and legal structure of a project, which usually incorporates a pre-default cash-flow waterfall, cash lock-up and sweep triggers, a timeframe before cash is released from lock-up, and debt-service reserve accounts for senior debt; and

• The terms and conditions of the underlying subordinated debt and any dedicated liquidity or debt-service reserve allocated for subordinated debt.

Accordingly, key subordinated debt ratingconsiderations include: how likely a project willgo into distribution or equity lock-up; how long itwill remain there; what happens to the trappedcash once in lock-up; and what type of credit orliquidity support (such as reserves) exist to lowerdefault probability. If a distribution-trapmechanism does not last for an indefinite period,it could be argued that the resumption of debt-service payments on subordinated debt--depending on the project, scenario, andsubordinated liquidity reserves--is likely to becertain. The analytical challenge is determiningthe duration of any under performance. Wetypically run stress scenarios for each project toanalyze how long it would take for a ratedtranche of subordinated debt to default undervarying scenarios. Nonetheless, any significantdeterioration in the performance of a project islikely to magnify the level of potential default onany subordinated debt.

What will affect the recovery of subordinated debt? If a project suffers from poor performance andthere is a missed payment of interest or principalon a project’s subordinated debt, a majordeterminant on the recovery prospects ofsubordinated debt is whether senior debt has alsodefaulted. If senior debt has not defaulted, itwould prevent any recovery action ofsubordinated debt until senior debt is repaid ordefaults. If this was to occur, there may be limitedor zero recovery for subordinated debt.

Should senior debt default or be repaid, factorsthat would influence the recovery prospects ofsubordinated debt include:

• The nature of the default;• The type of security, collateral, and any

first-loss protection;




• The type of security enforcement scenario (liquidation versus selling the project as a going concern);

• Senior debt’s ability to influence the recovery for its benefit;

• Macroeconomic conditions and its impact on the value of any collateral;

• The level of any break costs under a hedgingor derivative instrument;

• The insolvency or bankruptcy regime in a jurisdiction or country;

• Third-party costs, such as legal and insolvency-related costs;

• The time it takes to emerge from default;• The length and value of a project’s cash-

flow tail after the repayment of senior debt; • Any other equal-ranking obligations.

As each of these factors can vary considerablyfrom market to market across the globe, so toowill the level of recovery for each project’ssubordinated debt. Consequently, each projectneeds to be examined on a case-by-case basis.

Why can subordinated debt issues be rated oneor more notches below the senior debt rating?As each project’s business profile is unique, so toois its financial, contractual, and legal structures.Depending on the unique features of each project,our ratings on project subordinated debt issueshave on average ranged up to three notches belowthe senior debt rating. However, there have beenexceptions in both directions, depending on theproject and specific structural elements,covenants, and security features. Some creditfeatures that have led to subordinated debt beingrated more than one notch below senior debt (andhence more equity-like treatment) have included:

• Severe cash-flow encumbrances on subordinated debt servicing due to senior debt distribution lock-ups, the timeframe before cash is released from lock-up, and debt-service reserve maintenance;

• No rights or remedies in the event of a default affecting senior debt;

• No cross-acceleration or cross-default mechanisms; and

• Low debt-service coverage ratios and stress buffers.

Conversely, some credit features that have ledto subordinated debt being rated closer to thesenior debt rating have included:

• Contingent support from sponsors to mitigate cash-flow encumbrances on subordinated debt servicing;

• Lower probability of reaching equity lock-up, which could occur in a project due to simple services to be delivered, a benign payment mechanism, strong and/or highly rated service providers to whom cost and revenue deduction risk is passed, and considerable third-party support;

• Subordinated debt liquidity support in the form of a dedicated debt-service reserve (up to six months), the ability to capitalize or defer interest, PIK notes, and contingent third-party support;

• Sharing of collateral security enforcement rights with senior lenders; and

• Strong debt-service cover ratios and stress buffers.

There are also examples of subordinate debtbeing rated on par with senior lien obligations.These have occurred in situations where thesenior lien debt amounts are very small in relationto the subordinate lien, when a senior lien may beclosed, or when the project operates withsignificant financial margins. (For examples ofour ratings and related research on projectsubordinated debt issues, see the following issuerson RatingsDirect: 407 International Inc., ExpressPipeline L.P., Reliance Rail Finance Pty Ltd., SanJoaquin Hills Transportation Corridor Agency,and Alameda Corridor Transportation Authority.)

Where to from here for subordinated debt structures?As active competition for project andinfrastructure asset continues to move priceshigher, market participants will continue toexplore subordinated debt funding options andproduct structures to increase leverage to meetthis strong demand. So long as the economic cyclecontinues, market participants will continue topush boundaries in debt structuring; however,market participants should remember that debtstructuring is not a way to obtain funds at no risk


and that project fundamentals rather thanfinancial engineering are the key to investment-grade structures.

So where to from here? Given the long-termnature of project and infrastructure assets, andthe competitive nature of debt arrangers and therisk appetite of investors for long-term assets, thelandscape for project subordinated debt willcontinue to evolve. Standard & Poor’s expects tosee variations in subordinated debt products forproject and infrastructure transactions.

While cash flows from projects will continue tobe carved up to create subordinated debtinstruments, at the end of the day there is no“free lunch”, and the key credit consideration willremain--what will cause a rated tranche ofsubordinated debt to default and how will aparticular subordinated debt instrument affect thedefault or recovery of any senior-ranking debt? ■



Our first-ever public rating on a liquefiednatural gas (LNG) shipping entity wasrecently raised when Qatar-based Nakilat

Inc. was upgraded to ‘A+’ with a stable outlook.The rating on Nakilat, a wholly owned subsidiaryof Qatar Gas Transport Co. Ltd. (QGTC), wasraised following the upgrade of the State of Qatar(AA-/Stable/A-1+). This reflected our continuedexpectation of strong potential extraordinarysovereign support for Nakilat in an event ofstress. Since then, Standard & Poor’s RatingsServices has received several questions concerningour rating analysis of LNG shipping financings.Currently Nakilat is the only publicly rated LNGshipping entity and so, understandably, itrepresents the best case study of our ratingapproach. This article attempts to answer themost frequently asked questions we have beenreceiving concerning Nakilat and our generalcredit analysis of LNG shipping financings.Further information can also be read in the articletitled “Global LNG Shipping Projects May Be OnCourse For Investment Grade,” published onMarch 6, 2006, on RatingsDirect.

Frequently Asked QuestionsWhat are the major factors that underpinStandard & Poor’s approach to rating LNG ship financings?Generally our approach is to consider LNGshipping as an integral part of the complete LNGsupply chain, which starts from natural gasdevelopment and production from the gas field,moves through liquefaction of the natural gas,and ends with regasification at the importterminals and then sale to the end markets. Thetwo key elements that underpin our approach arecounterparty risk and the legal structure(including construction and charter agreements).

Counterparty risk. One of the key elements determining the ratingfor LNG ships is related to counterparty risk,specifically to the upstream project producing theLNG. In most, if not all, cases the project is thesource of payments to the shipper. If the projectfails, the alternative use for the LNG ships is stilllimited given the absence of a large LNG spotmarket. As a result, the credit quality of theunderlying LNG project usually provides one ofthe key constraints for the rating of the LNG ship

financing. The upstream project is often also thecharterer under the charter agreement. If there isan alternative charterer other than the projectcompany the credit quality of the alternativecharterer would also be important, because itprovides a measure of the certainty and reliabilitywith which cash flows will be earned by the vesselowners under the charter agreement for thepurposes of repaying debt.

There is also a counterparty risk inherent in theconstruction of ships. The credit quality,experience, transaction support through third-party liquidity, and reputation of the shipbuilderare also essential elements, therefore, in theoverall analysis of an LNG shipping project.

Legal structure (including construction andcharter agreements).The second key element in our analysis is the riskto lenders that arises based on the charterpartycontract and construction contracts. For aninvestment-grade rating we would expect thecharterparty contract to last through the debttenor and guarantee availability-based fixedpayments with inbuilt escalation clauses to covergrowing operating and material costs. Forconstruction contracts we would expect fixed-price, date-certain arrangements with establishedshipbuilders coupled with shipbuilder-completionguarantees.

Most LNG ship financings we have reviewedhave been structured as projects and have usedspecial purpose entities (SPEs). There are specificcontracts and documentation for single ships,although often several ships are operated as agroup. In effect, the financings have involved aportfolio of ships with the contractual naturebeing determined on a ship-by-ship basis. For thesingle ships we look to our project finance criteriain analyzing underlying risks given the single-assetnature of the SPEs and the contractual structure.In many cases, however, there is a holdingcompany sitting on top of the SPE that ultimatelyowns multiple ships, albeit through an SPEstructure. The review of the holding company aspart of a portfolio review might, therefore,require more of a corporate analysis. Ultimately, aportfolio of LNG ships is often presented as ahybrid structure featuring both project andcorporate features. Our rating analysis, therefore,has to take into account these unique features.


Publication Date:

April 13, 2007

Primary Credit Analysts:Karim Nassif, London, (44) 20-7176-3677

Terry A Pratt, New York, (1) 212-438-2080



CREDIT FAQ: RECENTLY UPGRADED NAKILATPROVIDES CASE STUDY FOR CREDIT ANALYSIS OFLNG SHIPPING PROJECTS


What approach did you take when analyzing Nakilat?We regard Nakilat as more of a corporate entitythan a typical project financing, due to the strongcorporate features inherent in the transaction.Ultimately our ratings on Nakilat reflect themainly corporate nature of the entity. Althoughsome features of its lending package arestructured like a corporate, however, its cash flowarises from asset-specific features. We, therefore,also analyzed some aspects of the transaction as ifit were a project.

We also consider Nakilat to be a government-related entity. Our conclusion of this governmentlink is supported by the importance of Nakilat’sLNG ships to Qatar’s economy and the state’sstrategic plans to maintain its leading position asthe world’s No. 1 LNG exporter. The overallcapital investment by the Qatari state and itspartners in the LNG sector (upstream, midstream,and downstream) is expected to total just over$65 billion by 2010.

Qatar and QGCT plan to use the Nakilat LNGships on some of the major LNG projects inQatar. These include Ras Laffan LiquefiedNatural Gas Co. Ltd. (3) (senior secured debtA/Stable), Qatar Liquefied Gas Co. Ltd.(QatarGas) 2, QatarGas 3, and QatarGas 4. Thegovernment is involved directly through itsownership of Qatar Petroleum (AA-/Stable/--),which is a majority owner of the LNG projects.Therefore, the ratings on Nakilat are linked to thecredit quality of the Qatari state (currently ratedAA-/Stable/A-1+).

Nakilat’s financial profile is weak for theratings but its business profile and strategy arevery strong. Given the company’s important rolein the Qatari LNG sector, which is a strategicsector for the nation’s GDP growth, we expectthat as long as the government stands behind itsLNG and gas monetization strategy, it willsupport Nakilat.

The one-notch differential between thecorporate credit rating on Nakilat and thesovereign rating on Qatar reflects the absence ofexplicit financial state support in the form of aguarantee or equivalent, despite implicit statesupport for the entity.

What impact did the Qatari sovereign upgradehave on the Nakilat ratings?Following the upgrade of Qatar we raised ourcorporate credit rating on Nakilat to ‘A+’ with astable outlook. The subordinated debt was alsoraised, to ‘A’. The senior secured debt rating wasaffirmed at ‘A+’.

The one-notch increase in the corporate creditrating reflected the one-notch increase in therating on Qatar and our top down approach forNakilat as a government-related entity. Thecorporate credit rating continues to reflect ourunchanged expectation of potential strongextraordinary sovereign support for Nakilat in anevent of stress. The senior secured debt rating(previously one notch above the corporate creditrating) remained unchanged because, although theavailable security package and debt structureshave not changed, the higher corporate rating onNakilat now means that the added value of thesecurity package relative to the rating is reduced.Similar sovereign support for the subordinateddebt is expected as for the senior debt, and forthat reason a one-notch differential between the corporate and subordinated debt ratings was maintained.

How does the sovereign rating influence theratings on LNG ship projects?In the case of Nakilat, the importance of LNG forQatar and the implicit support provided by thestate through the involvement of Qatar Petroleumalong the supply chain supports our conclusionthat Nakilat is a government-related entity. In asense Nakilat is a unique entity given the state ofQatar’s LNG strategy. In other instances wherestate support is not deemed as significant, aproject might not receive the same benefits ofstate support as Nakilat and the focus willtherefore be more on that project’s own strengthsand weaknesses. As noted above, thecreditworthiness of the LNG shipping deal wouldbe affected by the credit profile of the underlyingLNG supply project. For a project to obtainrating uplift toward a sovereign rating, thestrategic rationale for the country’s LNG sectormust be very strong--that is, material to thatcountry’s government. In other words, the



government’s financial position would bematerially harmed if the shipping entity were todefault. Government ownership of a shipping company and direct financial support mechanismsare also ways to link the rating on a shippingproject more closely to that of the sovereign. As with project finance analysis, sovereign andinstitutional risks are assessed as well as credit enhancements.

Could LNG ships have a rating above theunderlying project rating?Typically the creditworthiness of the underlyingLNG supply project will constrain the rating ofthe shipping deal. The two are inextricably linkedin the value chain because the ships rely on theproject to produce the LNG and the project ispaying the charter fees. It might be possible,however, for the LNG shipping project to achievea rating above that on the supply project if somedelinkage is achieved from the underlying supplyproject. In this situation, we require comfort thatthe ships could earn sufficiently robust cash flowwithout the supply project, through eitherredeployment by obtaining long-term contracts orthrough the spot market. In this case, our charter-hire price assumptions would be very conservativegiven the likely long-term nature of the debt. Thissituation might be more realistic in the long termthan in the short-to-medium term, assuming thatin the long term a deeper spot market develops.The current high amount of ships contracted forLNG projects, the lack of a deep LNG spotmarket, and the expectation that older-generationLNG ships might also be available for the spotmarket once their charter agreements end, allrender unlikely the potential redeployment of thevessels at rates commensurate with servicing ofdebt under severely stressed scenarios.

What recovery potential would you ascribe toLNG ships?Although we have not issued any public recoveryratings on LNG ship projects and continue torefine appropriate recovery scenarios, our analysisof recovery potential for LNG ship financings islikely to include an assessment of theredeployment of LNG vessels after a projectdefault in a similar way to the process describedabove under a delinking approach. Given the

absence of any material sale and purchase marketfor LNG vessels, we would not typically ascribemuch value to an enterprise value approach (suchas using EBITDA multiples or net present values)when calculating our recovery ratings. Rather, wewould likely focus our recovery analysis on theability of the vessels to continue to service debtunder low charter-hire rate assumptions, whichcould reflect historical lows witnessed in the spotmarket or long-term charter market or futurelows anticipated in either market as appropriate.

Do you view LNG ship projects with more thanone vessel as less risky than single-ship deals?All else being constant, the greater the number ofships involved for a given financial profile, thegreater the potential for higher ratings. Addingdiversity can reduce operational risk as well asexposure to force majeure risk by having a safetycushion consisting of a residual operating fleet inthe event that specific problems occur with someof the vessels. Although the LNG shippingindustry has a very favorable performance record,the risk remains that some vessels might havetheir payment streams affected due to technicalproblems, political risk, or environmentalconditions. The technical risk issue is presentbecause LNG ships are becoming much larger toimprove economies of scale and are employingreconfigured drive systems.

If we were to hypothetically compare astandard single-ship project serving the sameunderlying LNG project (with all other risksremaining constant) with a multiple-ship projectserving the same underlying LNG project, thechances are that rating would not be necessarilyenhanced by having more ships. There wouldlikely be more financial cushion at the samerating category for the LNG ship project with ahigher number of vessels. The reason is that underthe two different scenarios the credit quality ofthe same underlying LNG project continues toprovide a constraint on the rating on the LNGshipping projects. Nevertheless, there could beexamples where a ship project, because of itsparticular risk features, benefits by virtue of beingstructured with a large number of vessels, andtherefore manages to achieve a rating above thatof the underlying LNG project rating.



What leverage levels and debt service coverageratios are required to ensure an investment-graderating for LNG shipping projects?There are simply no magic numbers for debtservice coverage ratios or leverage levels thatwould guarantee an investment-grade rating.Ultimately the financial risk that a project orentity can absorb is derived from the underlyingproject risks, structure of financing, liquidity, andother factors. As a starting point, the financialratios are a result of the underlying risk analysis.One typical element of LNG ship financing is arefinance risk that is often incurred, despitecontracts backing the transaction far beyond theanticipated refinancing or initial maturity date.Although we consider this a weakness, it can,nevertheless, be somewhat mitigated through arefinancing strategy as well as incentives to startlooking early at refinancing (such as margin orcoupon step-ups and cash sweeps). The mostimportant mitigating factor is, however, the saleand purchase agreements that will support thetransaction far beyond the refinancing date andprovide comfort to the financial markets that theentity will generate sufficient cash to repay thenew debt. ■



STANDARD & POOR’S METHODOLOGY FOR SETTING THECAPITAL CHARGE ON PROJECT FINANCE TRANSACTIONS


In recent years, project debt issuers worldwidehave increasingly been using financialguarantee insurance provided by monoline

insurers, also referred to as monoline wraps. Akey element in the process of the monoline wrapis the capital charge Standard & Poor’s assigns.This capital charge is important for determiningthe capital adequacy of, and ultimately the ratingon, the monoline insurers. This article aims tomake transparent the way Standard & Poor’sdetermines each project’s capital charge andsupersedes the capital charges listed in our GlobalBond Insurance criteria book, which are no longervalid for project finance transactions.

A monoline wrap provides an “unconditionaland irrevocable” financial guarantee from theinsurer to pay all or a certain portion of aproject’s scheduled principal and interest on timeand in full to debt providers if the project isunable to do so. The project debt guaranteed bythe monoline is assigned a higher rating than theproject’s underlying rating. This higher rating isequalized with the financial strength rating on themonoline. The underlying project debt rating,which Standard & Poor’s assigns to each wrappedproject, is generally lower, reflecting the project’sreal underlying business and financial risks. As aresult of providing the guarantee, monolines areexposed to the underlying risk of the project. This determines their portfolio risk and the chargeto capital.

Each project finance transaction is unique, bothin terms of risks and structural features, and so isthe capital charge. Consequently, Standard &Poor’s uses the same methodology for everymonoline insured project to calculate theapplicable capital charge.

Capital charges have been assigned by Standard& Poor’s since the mid 1980s but have beenadjusted over time to reflect credit conditions andmarket trends.

Defining The Capital ChargeCapital charge is the theoretical loss based on aworst-case economic environment, i.e. aneconomic depression case. The capital charge isexpressed as a product of:

• Likelihood of default by the issuer (i.e. default risk or frequency); and

• Severity of default measured in terms of loss in asset value recovery.

The default risk is equivalent to Standard &Poor’s default probability at a given rating. It doesnot vary between different projects that have beenassigned the same rating. The severity factor istransaction specific, however, because each projecthas a unique combination of asset-related risksand contractual, financing, and legal issues.Consequently, the capital charge varies acrossasset classes and primarily reflects differences inthe recovery potential.

Once the two factors have been determined, the capital charge for issues is a percentage of par value.

Standard & Poor’s applies the same capitalcharge across an entire rating category. Issuesrated ‘A’, ‘A+’, and ‘A-’, for example, have thesame capital charge. Once a capital charge hasbeen assigned, Standard & Poor’s reviews itregularly as part of its surveillance.

Furthermore, the same capital charge is used forall the insurers involved in that project,irrespective of which insurer provides the wrap.This is because the transaction default frequencyand severity measure reflect the project risks andare independent of the insurance company thatinsures the project debt.

The process of estimating capital charges can becomplex and involve reasoning and modeling.Empirical data on new asset classes or newfinancing types, for example, is not alwaysavailable or useful. Estimating loss-given defaultcan also be complex in countries where thecreditor regime has not been tested or theenforcement of security is complex and lengthy.

The fundamental approach to calculating thecapital charge for project debt is generally thesame as that adopted for corporates.Nevertheless, the financing and structural aspectsof a project can demand subjective judgment ofrecovery potential, and therefore the capitalcharge. Even so, similar transactions under asimilar creditor regime are often likely to providea good benchmark for a new transaction.

Prerequisites Assigning an underlying rating to the project is arequired step toward enabling the calculation ofthe capital charge. The underlying rating isdetermined in the same way as an unwrappedproject debt rating and is based on the samecriteria. The underlying rating is determined

Publication Date:

Sept. 12, 2007

Primary Credit Analyst:Lidia Polakovic, London, (44) 20-7176-3985

Parvathy Iyer, Melbourne, (61) 3-9631-2034

Secondary Credit Analysts: Arthur F Simonson, New York, (1) 212-438-2094

Dick P Smith, New York, (1) 212-438-2095

David Veno, New York, (1) 212-438-2108

irrespective of whether the monoline guaranteeapplies to all the project debt or only a portion of it.

Standard & Poor’s relies only on in-housedeterminations of default frequency and recoveryestimates. Ratings and recovery values estimatedby other rating agencies or professional bodies arenot used as reference points for assigning thecapital charge. The in-house data enable Standard & Poor’s to maintain consistency across various jurisdictions, transactions, and operating environments.

Calculating The Capital Charge Default frequencyThe default frequency for a given rating isdetermined using Standard & Poor’s corporatedefault study. The default study identifies thehighest historical default rates across varioussectors by rating category over a period of years.The leading global economies, the U.S. andEurope, have not, over the past 15 years,represented a worst-case depression-like scenario,and so the default rates are grossed up to whatStandard & Poor’s believes to be worst-caselevels. Through simulations of such scenariosacross various sectors, Standard & Poor’scalculates worst-case default frequency for long-term risks across the rating categories (see table).

Loss-given defaultLoss-given default is unique for each project, forthe reasons given in “Defining The CapitalCharge”. It can differ between two assets in thesame sector and jurisdiction. There can also bedifferent degrees of confidence regarding recovery.Subjective judgments are critical for deciding howto stress collateral values in hypothetical post-default scenarios, but market trends cansupplement theoretical estimates. For the purposesof assigning a capital charge, Standard & Poor’scurrently assumes a maximum recovery of 90%.

Example.This example gives an illustration of how thecapital charge on a project rated ‘A’ is determined.The steps are: to determine the ‘A’ underlyingrating on the project; read the default frequencyfrom the table above; estimate the loss-givendefault; and finally determine the capital charge.

• The project’s underlying rating is ‘A’.• The default frequency for the ‘A’ rating

category is 7.1%.• The estimated asset recovery value is 60%.• The loss-given default is 40% (100%

minus 60%). • The capital charge is 7.1% multiplied by

40%: 2.84% of par value.

Cross-border issuanceProjects located in one country often raise debt inanother market. Such situations give rise tosovereign-related risks that could affect the abilityand willingness of the entity to service its foreigncurrency debt. In the past, we adjusted capitalcharges to reflect these risks. Effective this year,however, our methodology for calculating capitalcharges for project cross-border issuance has been revised.

Based on evidence that sovereigns underpolitical and economic stress are less oftenrestricting nonsovereign entities’ access to theforeign exchange needed for debt service, cross-border transactions (even without structuralsovereign risk mitigation features) can be ratedabove the sovereign foreign currency rating, up tothe “Transfer and Convertibility RiskAssessment” for the relevant sovereignjurisdiction. Project ratings incorporate alltransfer and convertibility risk and other relevantcountry risks. Furthermore, many cross-borderproject finance transactions contain significantadditional structural mitigants for direct sovereigninterference risk, which make an additional“sovereign risk” adjustment to the capital charge unnecessary.

Our new methodology for setting the capitalcharge for cross-border project financetransactions is therefore based on the default rateassociated with the transaction’s foreign currencyrating and severity of loss-given default. The latterwill continue to be an analytical assessment basedon the unique characteristics of each individualtransaction analyzed by Standard & Poor’s.

Rating category Worst-case default frequency (%)

AA 5.9

A 7.1

BBB 14.8

BB 55.4

Worst-Case Default Frequency





Surveillance Of The Capital ChargeThe capital charge is dynamic and all projectsthat have a monoline wrap have been surveilledsince 2005. This surveillance enables anadjustment to the capital charge if the underlyingproject’s default risk or recovery prospectsimprove or worsen.

The Capital Charge And New RatingsProject debt issuers and monoline insurers areencouraged to begin dialogue with Standard &Poor’s at an early stage in the project-financingprocess to help avoid any surprises later on. Earlydialogue is particularly important because mostprojects are rated at the lower end of the ratingscale, where the capital charge is substantiallyhigher and can affect the premium payable to themonoline. Borderline differences in ratingoutcome can have a substantial impact on theapplicable capital charge.

Standard & Poor’s is often asked by monolineinsurers to give indicative capital charges,sometimes even before the rating process isinitiated. We provide this indication based onestimated default risk and recovery levels. Onlyonce the rating (default risk) has been assigned toa project and the recovery rate determined is thefinal capital charge calculated. The final capitalcharge can therefore differ from the indicativeone, as the latter is based on estimates and onvery limited information. ■

SWEDEN MOVES CLOSER TO PPP MODEL AS ALTERNATIVEFINANCING FOR INFRASTRUCTURE ASSETS


Project Investment (bil. SEK) Details

Malmö city tunnel 9.5 (4.6 used) Financed by the government, the municipality of Malmö, the county council of Skåne, and EU contributions

Hallandsåsen railroad tunnel 7.5 N.A.

Citybanan line in Stockholm 13.7 (1.0 used) SEK4 billion to be financed by Stockholm municipality and Stockholm county council

Botniabanan railroad in northern Sweden 13.2 (9.5 used) N.A.SEK--Swedish krona. N.A.--Not available.

Table 1 - Major Rail Projects In State Budget


Sweden is making significant steps indeveloping a model for public-privatepartnerships (PPPs) to provide an alternative

means of financing public infrastructure. On June18, 2007, a joint working group commissioned bythe Swedish government--made up of the publicrail authority (Banverket), the public roadauthority (Vägverket), and the Swedish NationalRoad and Transport Research Institute (VTI)--published a proposal for a Swedish PPP modeland identified a number of potential future PPP projects.

Recently, the country’s public road and railwayauthorities announced the deferral of a substantialnumber of state-funded investments. A solutioninvolving PPP financing could minimize futuredelays in necessary infrastructure developments.For private investors, the existence of a projectpipeline detailing projects in terms of bothnumber and size is important, given the relativelyhigh costs associated with PPP bidding. It is alsoimportant for the public sector, to keeptransaction costs low.

For now, however, it is not clear if the PPPmodel will be selected and used on a larger scale,and, if so, how long implementation will take.

Large Investment Needed, But Grants MightNot SufficeCurrently, transportation infrastructureinvestments are funded mainly through the statebudget on a year-by-year basis. State budgetgrants for road investments for the 2006-2009period total about Swedish krona (SEK) 70 billion(SEK17 billion-SEK18 billion per year), whileearmarked spending on rail for the period comesto about SEK52 billion (SEK11 billion-SEK14billion per year) (see table 1).

While the need for investment in infrastructure,

mainly roads and rail, is evident in certain regionsto develop economic growth, in other areasinvestment is needed to alleviate congestion. Inthese cases, the approval of projects via thebudget on a year-by-year basis could prove tooslow to meet increasing demand. In addition,budgeted state contributions for the infrastructuresector have remained largely unchanged, failing toreflect cost increases. Recently, both theVägverket and the Banverket announcedsignificant investment reductions due toinsufficient funding. As an example, totalVägverket investment grants for 2007 amount toSEK42.5 billion, unchanged from 2004, whileconstruction costs have increased by 16% since2004. Consequently, the Vägverket has had to cutspending on projects by a similar amount.Although investments can be delayed on a short-term basis, the Vägverket is concerned about thelong-term effects on road quality and safety if thissituation continues. The rail sector faces a similarsituation, with capacity shortages in major citiesand traffic disruptions. If investment spendingremains unchanged, investments in infrastructureare likely to slow further.

The current system, in certain cases, allowspublic authorities with access to budget funds tofinance major projects by taking loans from thenational debt office. Total debt issued by thenational debt office to the Vägverket and theBanverket stood at SEK32.4 billion at year-end2006. In some cases the government (Kingdom ofSweden; AAA/Stable/A-1+) has guaranteed privatedebt, as in the case of the Öresund bridgebetween Sweden and Denmark. In rare cases,infrastructure investments are financed by chargespaid by the user (for example the train linkbetween Stockholm and Arlanda airport and theSvinesund bridge between Sweden and Norway).

Publication Date:

Nov. 2, 2007

Primary Credit Analyst:Lidia Polakovic, London, (44) 20-7176-3985

Secondary Credit Analysts: Karin Erlander, London, (44) 20-7176-3584

Michael Wilkins, London, (44) 20-7176-3528

Public And Private Support For Change The active search by the Swedish governmenttogether with public entities and private partiesfor a new model to finance public infrastructuremarks a change from the past. InfrastructureMinister Åsa Torstensson has said that thegovernment is looking at alternative financing forinfrastructure investments, with the intention offinding ways to achieve PPP solutions. The minister considers that there is a directconnection between new jobs, welfare, andefficient infrastructure.

If the government and parliament approve abroad domestic PPP initiative, a concessionalframework will have to be developed. Astandardized PPP regime with similarities toexisting regimes in Europe and elsewhere couldattract more potential bidders. Concessions mustbe designed to provide optimum value, not onlyfinancially but also in terms of other targets.Environmental issues have recently becomeincreasingly important in Sweden, as in manyother countries. Setting the right goals andrequirements from the start is key due to the long-term commitments involved.

These considerations have been addressed by the findings of the joint working group, which propose a Swedish PPP model andpotential projects.

Working Group Scrutinizes PPP AlternativeThe findings center on the profitability of projectsboth from a social and economic perspective,transparency of state funding, procurementcompetition to ensure efficiency and lower costs,and a system that allows for program evaluation.Innovation to introduce more efficient solutions,flexibility, and the potential to start projects atshort notice were also identified as key features ofa future PPP program.

The key findings are:• Quality, safety, and environment. The

investment should be of good quality, open to traffic, fulfill safety requirements, and ensure that environmental regulation is met.

• Effective risk allocation. The project company should carry construction, operational, and lifecycle risks. The state should be left with risks associated with the use of the asset (for example traffic volume risk) as well as those risks that could be

better managed by the state (such as acquisition of land, permit processes, pollution, and archeological finds). In the longer term, the working group believes more appropriate risk allocation measures should be developed.

• Financing. This should be a combination of a project’s own capital and borrowing to ensure that the sponsors’ incentives are in line with the aim of the project and that they remain committed.

• Public financing as a last resort. If the agreements between companies and local/regional authorities fall short, the project should ultimately be financed by the state.

• A long-term pipeline. PPP projects should be selected in line with long-term plans in order to control the expansion of infrastructure. Importantly, the working group believes it would be reasonable for the Swedish parliament and government to ultimately decide on the projects to be tendered, as long as taxes continue to finance the asset.

• Comparison with public finance. The working group believes that a rule should be established to enable the government to directly compare the cost of a project, to ascertain whether it should be financed via a PPP contract or purely via public funds.

• Drilling down. The PPP model should be applicable to smaller projects in the future, once the fixed costs of the bidding process are decreased.

Essential Criteria Identified To FacilitateProject SelectionIn the same report, the working group identifiedprojects it believed suitable for PPP financing. Itachieved this by first establishing the criteria aproject must fulfill:

• Investment volume: The amount invested should be between SEK1 billion and SEK3 billion.

• Planning stage: The design plans should be final and must be legally approved.

• Profitability: The project’s profitability should measure “nettonuvärdeskvot” (NNK; a ratio that calculates society’s benefit from a project) of at least 0.5x.

• Competition: The project should attract




both national and international interest.• Holistic approach: The project must take

due regard of lifecycle costs.• Duration of the contract: Approximately 25

years should be permitted, with no reconstruction in the near future.

• Final financing: This should be through cofinancing. Alternatively, user fees could finance all or part of the investment.

Pipeline Of Potential PPP ProjectsThe working group identified four projects itbelieved to fulfill all key criteria (see table 2).

The working group subsequently identifiedprojects that could be suitable for PPP, but thatdo not currently fulfill all essential criteria (see table 3).

Similarly, the working group identified railroadprojects that should be continually evaluated as totheir suitability for PPP financing. These are:Railroad East (Ostlänken); Railroad Norrbotten(Norrbotniabanan); a railroad between Mölnlyckeand Rävlanda/Bollebygd; a railroad betweenMalmö, Staffanstorp, and Dalby(Simrishamnsbanan); and combination terminalsand connections to harbors. ■


Length (kilometers) Investment (mil. SEK) NNK* (x)

E22 motorway between Kristianstad and Karlshamn 53 1,430 0.5

E22 motorway between Karlshamn and Jämjö 69 (74) 1,840 0.0

E22 Söderköping motorway 17 700 0.7-1.9

E6/45 new connection to river 1.5 2,500 2.2

E20 motorway between Alingsås and Vårgårda 25 1,550 0.5

E4 motorway between Hjulsta and Häggvik 7 4,500 0.2

E4 motorway between Södertälje and Hallunda 15 3,300 N.A.

E12 Umeå motorway (Umepaketet) 28 1,100 0.0-2.1*NNK (nettonuvärdeskvot) measures profitability and needs to be at least 0.5x. SEK--Swedish krona. N.A.--Not available.

Table 3 - Prospective Projects That Meet Some Criteria For PPP Financing

Length (kilometers) Investment (mil. SEK) NNK* (x)

Riksväg 50 road between Mjölby and Motala 28 1,330 1.4

E22 motorway between Hurva and Kristianstad 41 (57) 1,100 (1,360) 0.7

E4 Sundsvall South motorway 22 2,500 0.9

Länsväg 259 Södertörn road 9 1,300 0.7*NNK (nettonuvärdeskvot) measures profitability and needs to be at least 0.5x. SEK--Swedish krona.

Table 2 - Prospective Projects That Meet All Criteria For PPP Financing

ABU DHABI NATIONAL ENERGY COMPANY PJSC

RationaleOn Sept. 28, 2007, Standard & Poor’s RatingsServices affirmed its ‘AA-‘ long-term and ‘A-1+’short-term corporate credit ratings on Abu DhabiNational Energy Company PJSC (TAQA)following TAQA’s announcement of its intention,subject to various regulatory and administrativeapprovals, to acquire Canada-based PrimeWestEnergy Trust for approximately C$5 billion,funded primarily by debt.

The affirmation reflects our expectation ofongoing implicit sovereign support for TAQAgiven the company’s importance to the Emirate ofAbu Dhabi (AA/Stable/A-1+) and its status as agovernment-related entity (GRE). The ratingscontinue to be based on a “top-down” ratingapproach, which takes the sovereign rating as thestarting point of the analysis, reflecting thecompany’s position as a key entity in Abu Dhabi’seconomy and its importance as a national vehiclefor global investment and public policy.

Following the PrimeWest acquisition, up to one-half of the company’s forecast EBITDA will likelybe generated outside of the United Arab Emirates(UAE). This is consistent with the company’soriginally stated investment policy to undertakeinternational infrastructure investments. Ouropinion remains that, in a financial stressscenario, unlike the company’s UAE-based assetsthat are, for example, critical to the provision ofwater and power to the Emirate, non-UAEactivities may not receive the same level andtimeliness of sovereign financial support.

In respect of this specific acquisition, however,Standard & Poor’s has analyzed the extent andtiming of support that could be forthcoming inthe event of a stress scenario. In this case, weunderstand that it is the Emirate’s intention totreat these non-UAE assets in the same manner asthose in the UAE. In addition, the Emirate’sreview of all acquisitions (including that proposedfor PrimeWest) and the proposed corporatestructure of the acquisition within the overallTAQA group of companies further substantiatethe sovereign’s likely support for these assets. Noexplicit guarantee has been provided, however.

Including the PrimeWest acquisition, TAQA hascommitted nearly $10 billion in the acquisition ofvarious energy-related assets outside the UAE inthe past 12 months. The acquisitions have beenbroadly consistent with the investment frameworkoriginally set out by management, although boththe pace of the acquisitions and the level of

investment in Canadian assets have been greaterthan originally planned. We estimate that theinvestments acquired to date are likely to be oflow investment-grade/high speculative-gradecredit quality on a stand-alone basis. A keychallenge for TAQA remains the successfulintegration and realization of anticipated returnsfrom these various acquisitions. As a result of thisdebt-financed investment activity, TAQA’sfinancial profile is very aggressive, characterizedby high leverage and relatively low interestcoverage levels. Standard & Poor’s willincreasingly focus on the credit quality of theunderlying investment portfolio and the strengthof the relationship with the sovereign as criticalelements driving the ratings. Investment in weakercredit quality assets, for example, increases thelikelihood that sovereign financial support will becalled on. Standard & Poor’s will meet withmanagement and Emirate representatives in thenext month to discuss the future investmentstrategy and the potential parameters and methodby which sovereign support can be given to the company.

LiquidityTAQA’s liquidity derives from its above-averageUAE dirham 6.239 billion ($1.7 billion; as at June30, 2007, prior to the execution of recentacquisitions) cash balance invested in variousshort-term deposits. The company also has anestablished $1 billion revolving credit facilityfrom a domestic bank.

OutlookThe stable outlook reflects Standard & Poor’sexpectation that there will be no major changes inthe implicit government support to the companyas a GRE. This implies that the state will supportTAQA in the event of financial distress shouldexisting or future investments not perform in linewith expectations. The outlook also assumes thatthe company will execute its business plansuccessfully and meet its financial forecasts.

The rating would be raised, or the outlookrevised to positive, if there is a similar change inthe rating or outlook on the sovereign, or in thecase of enhanced sovereign support. The ratingwould be lowered, or the outlook revised tonegative, if there is any weakening of sovereignsupport for the company or if the underlyingconsolidated credit quality of the investmentportfolio reduces. ■

Publication Date:

Sept. 28, 2007

Issuer Credit Rating:AA-/Stable/A-1+

Primary Credit Analyst: Jonathan Manley, London, (44) 20-7176-3952

Secondary Credit Analysts: Karim Nassif, London, (44) 20-7176-3677

Luc Marchand, London, (44) 20-7176-7111




AUTOROUTES PARIS-RHIN-RHONE


RationaleThe senior unsecured debt rating on the Frenchtoll road operator Autoroutes Paris-Rhin-Rhone’s(APRR) seven-year, €1.8 billion, revolving creditfacility maturing in 2013 is ‘BBB-’. The outlook isstable. As of May 25, 2007, the facility had autilization of €0.8 billion. At the same date, totaldebt was €6.4 billion.

Since its privatization in 2006, APRR is81.48% owned by Eiffarie (not rated), aconsortium controlled by Eiffage and MacquarieAutoroutes de France (MAF). The remainingshares are publicly held. Total debt at Eiffarie asat May 25, 2007, is €3.9 billion. The APRRgroup includes both APRR and Eiffarie, which,because Eiffarie is an 81.48% shareholder, leadsus to consolidate the debt of Eiffarie into APRR.We have fully consolidated Eiffarie’s debt andrelated interest expenses with those of APRRbecause we treat the two entities as one group fordefault analysis purposes. Eiffarie’s debt isnonrecourse to APRR.

APRR is the third-largest toll-road operator inEurope, with a network of 2,215 kilometers (km;1,370 miles) in service and 2,279 km underconcession until 2032. APRR group’s highwayconcession network is well located across centraland eastern France, representing the major axesbetween the two wealthiest French regions, Ile-de-France (AAA/Stable/A-1+) and Rhône-Alpes, andthe two largest French cities of Paris(AAA/Stable/--) and Lyon, as well as links toBenelux and Germany. APRR’s subsidiary AREAhas the major road network connection to theAlps, related ski resorts, and Geneva, Switzerland.The network therefore comprises key economicand tourist corridors to southern France. Nomajor new competing roads or transport links are expected.

The revolving credit facility is sized to supportabout two years of capital expenditures, debtrepayments to Caisse Nationale des Autoroutes(CNA; AAA/Stable/--), and working capital atAPRR following its acquisition by Eiffarie.

The ‘BBB-’ rating reflects the following risks: • APRR has an aggressive financial structure,

with low debt service coverage levels and high consolidated leverage, taking into account total debt at APRR and Eiffarie. Standard & Poor’s Ratings Services’ base case assumes traffic growth of 1.75% over the life of the concession, with consolidated

minimum debt service coverage at 1.31x. This minimum occurs in 2012, based on an assumed refinancing of the Eiffarie debt in 2011, and an assumed amortization profile post refinancing. Prior to the forecast refinancing, the minimum coverage ratio is 1.42x. Although this is low compared with other rated highways projects with traffic risk, the maturity and large scale of APRR’s road network mitigate this.

• The structure contains considerable refinancing risk, as significant debt amounts are due from CNA by 2018. We understand that APRR is currently looking at ways to refinance CNA obligations due in late 2007 and beyond. APRR also has large capital expenditure requirements, and the Eiffarie acquisition facility has little amortization until it needs to be refinanced. Although the revolving credit facility, the strong cash flow generating ability over the life of the concession, and an increasing cash sweep in the acquisition facility mitigate refinancing risk, it remains higher than that of comparable investment-grade transactions.

• Although Standard & Poor’s takes a concession financing approach to APRR, we regard the overall structural package, with regard to shareholder lock-in periods, as weaker than those of comparable investment-grade concessions. The privatization process resulted in lock-in requirements for Macquarie and Eiffage of two and 10 years, respectively. Given the importance of retaining two balanced shareholders in the structure, the absence of further structural mitigants to prevent the emergence of a dominant shareholder remains a key structural weakness.

• Traffic growth was weak in 2006, but has shown recovery in the first quarter of 2007. Traffic growth reported for 2006 at 1.3% was below what we considered to be a conservative assumption of 1.75% traffic growth under our base case. Nevertheless, although traffic growth has been low and is not expected to improve substantially over the short term, revenues have met budgeted targets and are expected to continue to do so going forward.

• Although about 95% of all debt at Eiffarie and APRR is hedged, the structure remains

Publication Date:

June 13, 2007

Issue Credit Rating:Senior secured debtBBB-; BBB-/Stable

Primary Credit Analyst: Karim Nassif, London, (44) 20-7176-3677

Secondary Credit Analyst: Alexandre de Lestrange, Paris, (33) 1-4420-7316



sensitive to interest rate increases. This is a key consideration, given the existing refinancing risk.

The following strengths offset these risks at the‘BBB-’ level:

• APRR benefits from strong and recurring cash flow generation, stemming largely froma mature and very large toll road network.

APRR’s concessions are regulated by supportive agreements, including management contracts that guarantee a minimum, inflation-linked toll rate increase for each five-year period.

• APRR benefits from the combined experience of Macquarie Bank Ltd. (A/Stable/A-1) and Eiffage in the financing, construction, and operation of toll roads worldwide, although this is Macquarie’s first major investment in French toll roads.

• APRR has a strong track record in toll road operation. The project is resilient to a number of downside scenarios, at the same time as being able to service debt at both APRR and Eiffarie. A zero traffic growth scenario results in a minimum debt service coverage ratio of 1.06x.

• APRR is the third-largest toll-road operator in Europe, with a network of 2,215 km in service out of 2,279 km under concession until 2032, after Italy-based Atlantia SpA (A/Negative/A-1) and French peer Autoroutes du Sud de la France S.A. (ASF; BBB+/Negative/A-2). APRR’s 2006 turnover and EBITDA were €1.67 billion and €1.07 billion, respectively, up 6.3% and 9.7% on 2005 and in line with expectations.

As at Dec. 31, 2006, APRR complied with the financial covenants set by the state as part ofthe privatization.

The APRR network has shown moderate, butbelow budget, traffic growth of 1.3% overall forthe 12 months to end-December 2006 comparedwith the same period of the previous year. Thisremains weaker relative to APRR’s peers ASF andCofiroute (BBB+/Negative/A-2), but similar totraffic growth reported by French toll roadoperator Sanef (A/Negative/A-1) for the period.Poor weather conditions in the first quarter of theyear and a heat wave in July that affected lightvehicle traffic were responsible for lower-than-

expected traffic growth, somewhat offset by anupturn in the French economy and completion ofrepair work at the Epine and Fréjus tunnels.Overall revenues grew by 6.3% in 2006 year onyear, exceeding budgeted targets by about €24million. Improvement in total revenues reflectedthe contractual increase of rates in October 2005and 2006, as well as a rebound in heavy trafficvolumes and reduced discount rates for heavyvehicle subscribers. EBITDA margins improved by2% in 2006 compared with the previous year. Weexpect EBITDA margins to continue improving by1% per year over the short term based on similartraffic growth and continued implementation ofcost controls and operational efficiency. Traffic growth for the first quarter of 2007 was3.5% above that of the same period the previousyear due to better weather and macroeconomicconditions.

Outlook The stable outlook reflects our expectation ofcontinued stable, recurring cash flows from theroad network under the concession agreements.The ratings could be lowered if one of the keysponsors gains a dominant position in thestructure (in which case the ring-fencing would nolonger hold), traffic falls consistently below ourbase case assumptions, or if the refinancing doesnot proceed as assumed in the base case. Upgradepotential is limited. Eiffage is subject to a take-over bid by its major shareholder Sacyr, a Spanishconstruction company, but we do not expect anychange of ownership to affect the structure andworking of the APRR group.

Concession Financing FactorsThe structure implemented following privatizationled us to adopt a concession financing approachto APRR, rather than the previous corporateapproach. This was due to:

• Compliance with Standard & Poor’s criteria for special-purpose entities at the level of the Eiffage and Macquarie consortium, which owns the majority of APRR after privatization;

• Restrictions on individual sponsor control in APRR, owing to Eiffage and Macquarie’s roughly equal shareholder ownership;

• Commitment of the two shareholders to maintaining their equity interests in the



consortium for at least two years (Eiffage has committed for 10 years); and

• The sponsors’ commitment to ensuring the single business focus of APRR.

The key supporting factor for our concessionfinancing approach is that the sponsors’ respectivecontrol of Eiffarie and APRR is roughly balanced.If this were to change--for example through onesponsor selling its equity interest to the other,leading to majority ownership by a singlesponsor--we would likely review our ratingapproach to the structure. ■



RationaleOn Sept. 10, 2007, Standard & Poor’s RatingsServices kept its ‘BB+’ long-term and underlyingdebt ratings on the £1.620 billion combinedsenior secured bank loans and debt issued byU.K.-based underground rail infrastructurefinancing companies Metronet Rail BCV FinancePLC and Metronet Rail SSL Finance PLC(Metronet BCV and Metronet SSL; the Metronetcompanies) on CreditWatch with negativeimplications, where they were placed on May 22,2007. This follows the agreement of bilateralstandstill arrangements between Transport forLondon (TfL; AA/Stable/--) and the funders to theMetronet companies. A public-private partnership(PPP) administration order was granted overMetronet Rail BCV Ltd. and Metronet Rail SSLLtd. (the Infracos) on July 18, 2007.

At the same time, Standard & Poor’s affirmedits ‘AAA’ insured rating on the £165 millionindex-linked bonds and £350 million fixed-ratebonds outstanding at Metronet BCV, reflectingthe unconditional and irrevocable guarantee ofpayment of interest and principal by FinancialSecurity Assurance (U.K.) Ltd. (FSA; AAA/Stable/--) and Ambac Assurance U.K. Ltd.(Ambac; AAA/Stable/--), respectively. In addition,Standard & Poor’s affirmed its ‘AAA’ insuredrating on the £165 million index-linked bondsand £350 million fixed-rate bonds outstanding atMetronet SSL, reflecting the unconditional andirrevocable guarantee of payment of interest andprincipal by Ambac and FSA, respectively.

As at Sept. 10, 2007, Metronet BCV had £515million bonds and a combined £433 million bankdebt outstanding. At the same date, Metronet SSLhad £515 million bonds and £194 million bankdebt outstanding.

The CreditWatch status continues to reflect therisks and uncertainties regarding both the PPPadministration process and the ultimaterestructuring of the Infracos to deliver theirresponsibilities under their respective servicecontracts. The PPP administration process isuntested and the outcome is therefore uncertain.

On Sept. 4, 2007 a standstill agreement wasentered into between TfL and the funders to theMetronet companies (representing both the bondand bank debtholders) that will run until January2008. Under the terms of this agreement, TfL willprovide funding to the Metronet companies toenable them to fund the combined £46.4 million

debt service payment due on Sept. 15, 2007, andassociated financing costs including swappayments. In return, the funders will not take anyenforcement action to seek, for example,accelerated payment of the debt outstanding.

Standard & Poor’s expects that there will beongoing negotiations between TfL, LondonUnderground Ltd. (LUL), the PPP administrators,and the senior lenders in relation to the future ofthe PPP service contracts. On Aug. 24, 2007, TfLlodged an expression of interest to the PPPadministrators to take over the PPP contracts andassets of the Metronet companies. We believe thatthe most likely long-term outcome is that arestructuring of the contracts will occur that givesa new Infraco revised PPP service contractresponsibilities. The restructured contract will bebased on a new prioritization of servicerequirements, reflecting the revised level ofongoing infrastructure service charge (ISC) to bepaid to the Infracos. The support and role of thevarious parties to the PPP service contract,including the Statutory Arbiter, TfL, LUL, and theU.K. Department of Transport (DoT) will remaincritical to the analysis.

Standard & Poor’s will resolve the CreditWatchas the PPP administration process and thecontract restructuring proposal develops and thelikely outcome becomes clear. The long-term andunderlying debt ratings would be lowered if therewas a significant downturn in the Infracos’operating performance or it became clear thatexisting senior debtholders would not be keptwhole in any new Infraco structure. In particular,we will focus on the ongoing performance of theInfracos during the PPP administration assignificant performance-related deductions fromthe ISC may result in a deterioration in creditquality. In addition, we will monitor the ongoingprocess of negotiations between the relevantparties including TfL and DoT to understand thepotential ownership and capital structure of anynew Infraco that will assume the PPP servicecontract responsibilities.

Standard & Poor’s will also review the likelytreatment of senior debtholders within any newcapital structure to ensure that they receive fulland timely payment of debt service obligationsand that any restructuring proposal does notresult in a loss of value to the debtholders. Shoulda proposal be brought forward that would resultin a loss of value, the long-term and underlying

Publication Date:

Sept. 10, 2007

Issue Credit Rating:Senior secured bank loanBB+/Watch Neg; senior secured debt AAA,BB+(SPUR)/Watch Neg

Primary Credit Analyst: Jonathan Manley, London, (44) 20-7176-3952

Secondary Credit Analysts: Beata Sperling-Tyler, London, (44) 20-7176-3687

Liesl Saldanha, London, (44) 20-7176-3571


METRONET RAIL BCV FINANCE PLC/ METRONET RAIL SSL FINANCE PLC


debt ratings would likely be lowered. If theproposal was subsequently implemented, the long-term and underlying debt ratings would likely belowered to ‘D’.

Although the Infracos are in administration, wehave maintained the ‘BB+’ ratings on debt issuedby the Metronet companies, reflecting thestructural protections within the PPP servicecontract that are likely to benefit debtholders. Forexample, as an insolvency event has occurred forthe Infracos, the funders ultimately have theability to exercise a put option, requiring TfL topay a put option price--that is, at least 95% ofthe outstanding debt at each company. It istherefore unlikely that the funders will accept anyproposed restructuring that would result in themreceiving less than the amount they would receivethrough the exercise of the put option. There isno track record of implementing any of thesearrangements, however, including determining thevalue of the put option, or enforcing theseobligations. Although they provide significantcomfort at the rating level, the protections may besubject to challenge and delay.

If, as part of the PPP service contractrestructuring process, the various debt obligationsof the Metronet companies are assumed by TfL--prior to a final restructuring solution beingimplemented--the long-term and underlying debtratings could be raised. ■



RationaleOn June 20, 2007, Standard & Poor’s RatingsServices assigned its preliminary ‘AAA’ long-terminsured debt rating to the proposed £442.8million (including £50.0 million variation bonds)fixed rate guaranteed bonds due October 2042, tobe issued by U.K.-based health funding specialpurpose vehicle Peterborough (Progress Health)PLC (ProjectCo). The preliminary rating reflects the unconditional and irrevocablepayment guarantee of scheduled interest andprincipal provided by FGIC UK Ltd. (FGIC; AAA/Stable/--).

At the same time, Standard & Poor’s assignedits preliminary ‘AAA’ long-term insured debtrating on the liquidity facility, change-in-lawfacility (CiLF), and swap facility provided byABN AMRO Bank N.V. (AA-/Watch Pos/A-1+).The preliminary rating reflects the unconditionaland irrevocable payment guarantee of scheduledinterest and principal provided by FGIC.

The preliminary underlying long-term ratingson the proposed debt are all ‘BBB-’ with a stableoutlook. The debt and all the facilities have alsobeen assigned preliminary recovery ratings of ‘2’,reflecting expectations of substantial (70%-90%)recovery of principal in the event of a default.

Final ratings will depend on receipt andsatisfactory review of all final transactiondocumentation, including legal opinions.Accordingly, the preliminary ratings should not beconstrued as evidence of final ratings. If Standard& Poor’s does not receive final documentationwithin a reasonable timeframe, or if finaldocumentation departs from materials reviewed,Standard & Poor’s reserves the right to withdrawor revise its ratings.

The proposed debt will finance the design,construction, and operation of three newbuildings on two sites for three separate NationalHealth Service (NHS) Trusts as part of theGreater Peterborough Health Investment Plan:

• A new mental health unit will be built on the existing Edith Cavell Hospital site for Cambridge and Peterborough Mental Health Partnership NHS Trust (the MHU Trust).

• A new acute hospital will be built on the existing Edith Cavell Hospital site for the Peterborough and Stamford Hospitals NHS Foundation Trust (the Acute Trust).

• A new integrated care center will be built on the existing Peterborough District Hospital

site for the Greater Peterborough Primary Care Partnership Trust, which is acting through the Peterborough Primary Care Trust (the ICC Trust).

All three Trusts are acting jointly, but notseverally, via a project agreement (PA) with a termof 35 years and four months under a U.K.government private finance initiative (PFI)program. The Acute Trust has full terminationrights over the project, as it will provide about86% of the unitary payments, while the twosmaller Trusts only have termination rights overthe part they are responsible for.

The preliminary ‘BBB-’ underlying senior debtand facilities ratings take into account thefollowing project risks:

• The project is exposed to the counterparty risk of unrated Australia-based construction group Multiplex Ltd. and a number of its U.K.-based subsidiaries--also unrated--as shareholder, design, and construction contractor, and hard facilities management (FM) services providers. Although this integrated approach to project delivery might have advantages such as enhanced coordination, there is no diversification of counterparty risk.

• This is the first health construction project undertaken by Multiplex Ltd. in the U.K. Although the company has experience in complex construction projects worldwide, its experience in health construction is limited to a small number of relatively low-value projects in Australia. In line with standard industry practice, the works will be fully subcontracted in packages. Multiplex may, however, be subject to fallout from the difficulties it encountered during the construction of Wembley Stadium in terms of availability and pricing of suitable subcontractors. All fixed price appointments required before financial close have now been made, however, and the technical adviser, Faithful & Gould, considers them satisfactory. The size of the largest phase of construction (£280 million) may limit the number of contractors able to take over should Multiplex Construction (UK) Ltd. be replaced.

• This is also the first hard FM contract Multiplex Facilities Management UK Ltd.

Publication Date:

June 20, 2007

Issue Credit Rating:AAA (insured); BBB-(SPUR)/Stable (preliminary)

Primary Credit Analyst: James Hoskins, London, (44) 20-7176-3393

Secondary Credit Analysts: Lidia Polakovic, London, (44) 20-7176-3985

Hugo Foxwood, London, (44) 20-7176-3781


PETERBOROUGH (PROGRESS HEALTH) PLC


(Multiplex FM) has signed in the U.K. Multiplex FM has some health experience but on a smaller scale and with shorter contracts. It provides FM services to several hospitals in Australia totaling 2,100 beds--this PFI project alone provides 780 beds. The Australian contracts have an average duration of 10 years, significantly lower than for this project. The technical adviser has reviewed Multiplex FM’s processes and procedures and considers them satisfactory.

• Unlike most rated PFI projects to date, the project makes use of a liquidity facility and CiLF instead of cash reserve accounts. The facilities have minimal drawstops and should provide relatively timely liquidity to the project if required.

• The project is highly leveraged (94%) and the structure is quite aggressive with no tail.In lieu of a tail, a cash reserve is built up by the start of the last year of the concession, assuming sufficient cash is available.

• ProjectCo is exposed to increased labor costs beyond those budgeted for, and for which it cannot claim relief from the Trusts through the market testing process.

• The project is exposed to the uncertainty of more than 35 years of capital-replacement costs.

• The contractor is dependent on key personnel. Given its lack of experience in theU.K., Multiplex Construction (UK) has had to recruit a new construction team specifically for this project. As this experience is vested within individuals, rather than the organization, Multiplex could be exposed if it failed to retain the services of these personnel, as it would need to recruit externally, and therefore may not be able to rapidly transfer staff internally if necessary.

The following strengths mitigate these risks atthe preliminary ‘BBB-’ rating level:

• Construction risk is partially mitigated by an 18% (£60 million) LOC provided by ABN AMRO, which would be sufficient to fund construction delays of 12 months and replacement cost premiums of about 15% or more through the whole construction period.

• An LOC equivalent to about 20% of the annual hard FM fee and a cash reserve equivalent to about 20% of the annual hard FM fee (replaceable by an additional LOC for the same amount) by the planned commencement of full services provides third-party liquidity support for the hard FM services. This liquidity can only be removed once Multiplex FM has met specific performance and financial targets consistently over a three-year period.

• There are alternative hard FM providers capable of undertaking the services if Multiplex FM is replaced.

• A 24-month longstop date is included for the acute facility. This is significantly longer than for similar hospital projects (usually 12-18 months). The building contract longstop is 12 months, which gives ProjectCo a minimum 12 months to appoint a replacement contractor if necessary.

• The Trusts have invested significant resources in assessing the design and working with Multiplex to develop and verify the details. In particular, all 1:50 scale drawings have been signed off by clinical user groups before financial close.

• The construction works, although large, are relatively simple, with limited decanting and phasing requirements. A large part of the Acute and MHU hospital works are on a greenfield site next to the existing hospital.

• Capital-replacement risk is partially mitigated by a three-year, forward-looking lifecycle reserve, and a 12-year guarantee from the construction contractor for latent defects. Sensitivity testing also indicates that ProjectCo could withstand significant increases in lifecycle costs before encountering financial distress.

• Multiplex’s construction liability is limited only on termination to 55% of the construction contract sum. Termination liability steps down to 40% on completion of the Acute facility and to 20% six years after practical completion. In addition, the liquidated damages cap is sized to enable damages to be paid until the PA longstop date of 24 months from programmed completion. This is 60% of the expected construction period.


The liquidity facility is revolving and pari passuwith the senior debt in all respects. The facility isfully committed, and valid requests must behonored by the lender unless there is a liquidityfacility event of default outstanding. The facilityevents of default are limited to the following:

• Nonpayment of principal and interest on an outstanding liquidity loan.

• Each liquidity loan has a term of six months only. If the loan is not repaid within the term, a new request for an additional liquidity loan may be made by ProjectCo. The lenders must make a new liquidity loan available to repay the previous loan and meet any additional liquidity shortfalls so long as the maximum commitment of the facility is not exceeded.

• ProjectCo insolvency.• It becoming illegal for ProjectCo to make or

receive payments under the liquidity facility. • If the bonds are accelerated or the bonds are

made immediately due and payable under the terms of the collateral deed by the controlling creditor.

The facility may be drawn to service seniorliabilities, including liquidity facility payments.With written permission from the controllingcreditor, however, it may also be used to fundspecified operating costs as defined by theaccounts agreement. This applies only tooperational costs that are senior to senior debtliabilities in the operational cash waterfall. Theliquidity facility may not be used to fundincreases in capital costs. The distributioncovenant will be triggered if any liquidity loansare outstanding.

The facility is available from the start of theconcession until replaced by the earlier of anequivalent cash debt service reserve account, orthe end of the concession. Under the base case, acash reserve is to be built up toward the end ofthe concession to replace the liquidity facility.During this period, a full six-month debt servicereserve is available at all times, which will bebased on a part cash/part liquidity facility reserve.

Standard & Poor’s project finance ratingsapproach does not address the potential forchanges in law within its ratings methodology.The U.K. PFI standard form contract specificallyaddresses the allocation of risk in relation topotential future changes in law. In this project, the

standard risk allocation for change in law is adopted.

The Trusts will assume the risk ofdiscriminatory and NHS-specific changes in lawin terms of compensation and extensions toconstruction completion dates.

ProjectCo has shared general change-in-law riskup to a maximum liability of 3.13% of the capitalcost of the project during the operational period.During the construction period, general change-in-law risk has been passed in full to theconstruction contractor. Change in law in relationto medical equipment services is treated separatelyfrom this regime and is fully borne by the relevanttechnology contractor.

This project has a facility available to meetpossible change-in-law requirements during theoperational period of the concession. The change-in-law facility is pari passu to the senior debt andthe facility is available from the start of theconcession until the time of the mandatorydrawdown--scheduled to occur toward the end ofthe concession--of any undrawn proceeds, whichare deposited in the change-in-law account. Anydrawings used to fund valid changes in law beforethe mandatory drawdown are interest only untilthen and the facility is subsequently repaid undera predetermined schedule.

With prior written permission from thecontrolling creditor, the facility may also be usedto fund operational or finance costs. If it is usedin this manner, any drawings must be repaid infull (principal and interest) under a cash sweep,and the distribution covenant will be triggereduntil full repayment of the facility has been made.

The swap facility is provided under a standardform ISDA master agreement with a project-specific schedule. Standard & Poor’s has reviewedthe details of this agreement and confirmed that itcomplies with the criteria.

Recovery analysisThe senior secured debt and the facilities haveeach been assigned preliminary recovery ratings of‘2’, indicating Standard & Poor’s expectation ofsubstantial recovery of principal (70%-90%) inthe event of a payment default. To date, however,there has been limited experience regardingdefault or loss in this sector.

The senior debt facilities benefit from a strongsecurity package, covenants, and contractualfeatures for compensation on termination that are




standard in U.K. PFI transactions. The creditor-friendly U.K. insolvency framework gives securedcreditors of PFI transactions with step-in rightswho have floating charges the ability to appointan administrative receiver to enforce security andthereby control the insolvency process.

Additional features supporting substantialrecovery include the relative clarity of thetermination regime (although this remains largelyuntested), the expectation of timely repayment bythe Trusts according to defined procedures anddates, and the robust credit quality of the Trustsas payers of termination sums. Exposure to aTrust credit default following termination is,therefore, minimal.

The PA stipulates the mechanism fordetermining how ProjectCo (and its lenders) willbe compensated for various events leading totermination. In the event of a Trust default, forcemajeure, or a voluntary termination,compensation will fully cover senior debt service,i.e. 100% recovery will be possible. As the Trusts’responsibility is joint but not several, however, thePA only terminates for Trust default if the AcuteTrust (representing 86% of the unitary payment)defaults. If one of the two smaller Trusts defaults,full compensation is payable to ProjectCo instandard terms but the PA does not terminate.The medical equipment services agreement doesnot have any partial termination provisions.

A ProjectCo event of default arising from issueslike insolvency, prohibited change of control,construction delay beyond the longstop date (24months after the scheduled completion of theAcute hospital), material breach of obligations, oraccumulation of excessive penalty points,however, can trigger a termination where therepayment of debt is not guaranteed by the Trust.These scenarios have therefore been considered inorder to arrive at potential recovery rates.

Senior lenders have step-in rights to resolve aProjectCo event of default. If termination occurs,compensation is based on a market retenderingprocess (if a liquid market exists) or a net-present-value calculation, less certain expenses.

Recovery rates for the project should improveas time passes because debt will be paid downand reserves built up. The recovery analysisassumes a relatively unfavorable scenario where asevere delay occurs in the initial years ofconstruction, with a substantial increase in costsfollowing contractor replacement. Scenarios thatreduce the unitary payment by various amountshave also been considered, reflecting ProjectCo’sinability to achieve its original operatingperformance. The liquidity available to the projectthrough reserves (such as the guaranteedinvestment contract) and cash is factored into theanalysis. The recovery scenarios also assume thatboth the liquidity facility and the CiLF are fullydrawn at default.

OutlookThe stable outlook on the preliminary underlyingratings reflects Standard & Poor’s expectationthat construction will proceed in line with theplanned program and budget. This expectation isbased on the contractor’s ability and theprofessional team it has assembled, the favorableopinion of the technical adviser on the proposals,and the significant third-party constructionsupport provided. The rating could be lowered ifthere were substantial delays in construction--increasing concerns about the contractor’s abilityto deliver and maintain the hospitals--and/orsubstantially higher-than-expected cost increases.An upgrade in the short to medium term is unlikely. ■


RationaleThe £88.7 million index-linked senior securedbonds due 2036 and the £70 million EuropeanInvestment Bank (EIB; AAA/Stable/A-1+) loansdue 2034 issued by U.K.-based special purposevehicle Transform Schools (North Lanarkshire)Funding PLC (Issuer) have a ‘AAA’ insured ratingand a ‘BBB-’ Standard & Poor’s underlying rating(SPUR). The outlook on the SPUR is stable. Inaddition, the underlying rating on the bonds has arecovery rating of ‘2’, indicating Standard &Poor’s expectation of substantial recovery ofprincipal (70%–90%) in the absence of aguarantee in the event of a debt default.

The insured rating reflects the unconditionaland irrevocable payment guarantee of scheduledinterest and principal provided by XL CapitalAssurance (U.K.) Ltd. (AAA/Stable/--). Theunderlying ‘BBB-’ rating represents a composite ofcredit factors, outlined below.

The funds have been onlent by the Issuer toTransform Schools (North Lanarkshire) Ltd.(ProjectCo), and are being used to finance thedesign and construction of 17 new facilities for 24schools for North Lanarkshire Council inScotland. Following the completion ofconstruction, ProjectCo, via its subcontractorHaden Building Management Ltd. (HBML), willprovide hard and limited soft facilitiesmaintenance services, including buildingmaintenance, lifecycle, security, energymanagement, cleaning and janitorial services tothe schools for the remainder of the 32-yearproject agreement, which expires in 2037.

Construction commenced in October 2004under an advanced works agreement andcontinued under the private finance initiative(PFI) contract upon financial close in April 2005.Final completion is due to occur in October 2008and works are being undertaken by anunincorporated joint venture between BalfourBeatty Construction Ltd. and Balfour KilpatrickLtd. (construction joint venture; CJV), both ofwhich are subsidiaries of Balfour Beatty PLC (notrated). Construction works are currentlyproceeding reasonably well, with 11 facilitiessuccessfully completed, two facilities due to becompleted in October 2007, two in November2007, and the final two schools in October 2008.

The ‘BBB-’ underlying rating reflects thefollowing credit risks:

• Although the completion of this multisite project should be within the capabilities of

the contractor Balfour Beatty PLC to deliver successfully, it is being run concurrently with a number of other Scottish education PFI portfolio projects. The ability to procure sub-contractors to carry out key construction activities in a reasonably constrained labor market will be crucial, therefore, in ensuring construction delivery in line with the contractually agreed timetable. Furthermore, Balfour Beatty itself is undertaking a number of significant PFI projects at this time so its ability to manage this project alongside others will be challenging, although achievable given the company’s significant experience in the sector.

• One school facility, St. Ignatius and Wishaw Academy Primary, which was handed over in August 2007, was found to be about 136 square meters smaller than required by the output specification immediately prior to handover. In addition, one school is currently in delay by around 12 weeks due to poor ground conditions. ProjectCo is being protected from the financial impact of these two issues by CJV. At Wishaw, CJV is currently implementing the additional works required to bring the floor area of the school up to standard at its own expense.

• The project relies on about £23 million of revenue earned through phased construction to provide funding for further construction activities. Any delays to the attainment of these revenues could reduce the funding available for construction.

• The third-party financial support and liquidity during the construction phase is relatively low, although adequate. Construction risk is partially financially mitigated through an adjudication bond from Banco Bilbao Vizcaya Argentaria S.A. (AA-/Positive/A-1+).

• ProjectCo is exposed to the uncertainty, in terms of budgeting and timing, of more than 32 years of capital-replacement risk. This risk is partially mitigated by: a three-year forward-looking reserve; a 12-year limit on the construction joint-venture liabilities for serious latent defects; and the relatively simple nature of schools projects.

• The financial structure is aggressive, as is typical for the PFI sector. Senior debt to total funds is 90% (excluding construction


TRANSFORM SCHOOLS (NORTH LANARKSHIRE) FUNDING PLC


Publication Date:

Oct. 11, 2007

Issue Credit Rating:Senior secured debtAAA, BBB-(SPUR)/Stable

Primary Credit Analyst: James Hoskins, London, (44) 20-7176-3393

Secondary Credit Analyst: Jose R Abos, Madrid, (34) 91-389-6951

revenue), and base-case senior debt-service coverage levels are a minimum of 1.19x and average 1.21x, which is low but in line with most recently rated PFI projects in the U.K. In addition, forward and historical distribution lock-up levels are slightly lower than recent transactions at 1.125x. The financial model, however, performs satisfactorily under a range of stress scenarios.

These risks are mitigated at this rating level bythe following credit strengths:

• The project receives an availability-based revenue stream, with no volume or market exposure, no reliance on third-party revenues, and a relatively benign payment mechanism.

• The experience and capability of Balfour Beatty and its subsidiaries in their capacities as sponsor, constructor, and facilities maintenance (FM) provider.

• All individual schools will be 100% new-build, with construction on largely vacant sites within the existing school sites. Furthermore, the project is likely to benefit from the portfolio effect of construction on various sites.

• The FM service requirements are relatively simple and, therefore, are likely to be within the capabilities of the FM provider. In addition, benchmarking and market testing provides an adequate pass-through of operational risks from ProjectCo.

• With the exception of the two schools mentioned above, progress on the construction is adequate to date, with a total of eight sites (accounting for 11 schools) completed so far, with works having commenced on all tranche-2 schools as anticipated. A number of minor grantor-funded variations have been executed and relations between parties continue to be positive. Construction remains on schedule for final completion and handover in October 2008.

Recovery analysisThe secured bonds and EIB loan have beenassigned a recovery rating of ‘2’. This indicatesStandard & Poor’s expectation of substantialrecovery of principal (70%-90%) in the absenceof a guarantee in the event of a debt default. Todate, however, there has been limited experienceregarding default or loss in this sector.

This recovery rating reflects the strong securitypackage, covenants, and contractual features forcompensation on termination that are inherent inU.K. public-private partnership (PPP)transactions. A key feature supporting thisassessment is the creditor-friendly U.K. insolvencyframework. Secured creditors of PPP transactionswith step-in rights that have floating charges haveadditional advantages, because they are one of thecategories of creditors that can appoint anadministrative receiver to enforce security andthereby control the insolvency process.

Additional features supporting Standard &Poor’s expectation of substantial recovery includethe relative clarity of the termination regime(although this is largely untested), the expectationof timely repayment according to definedprocedures and dates by the procuring authority,and the robust credit quality of the procuringauthority as payor of termination sums. Exposureto authority credit default following terminationis, therefore, minimal.

OutlookThe stable outlook reflects our expectation thatthe necessary rectification works at St. Ignatiusand Wishaw Academy Primary will be completedto the satisfaction of ProjectCo and in a timelymanner. If further significant delays areencountered or the rectification works are notadequately completed the outlook may be revisedto negative or the rating lowered. There iscurrently limited scope for an upgrade. ■



Utilities

Name Issuer credit rating* Country

Acea SpA A/Stable/A-1 Italy

Acquedotto Pugliese SpA BBB/Negative/A-3 Italy

AEM SpA BBB/Watch Pos/A-2 Italy

Anglian Water Services Financing PLC Guaranteed debt AAA; senior secured debt A-; subordinated debt BBB U.K.

Artesian Finance PLC Senior secured debt AAA U.K.

ASM Brescia SpA A+/Watch Neg/A-1 Italy

Bord Gais Eireann A/Stable/A-1 Ireland

BOT Elektrownia Turow S.A. B/Positive/-- Poland

British Energy Group PLC BB+/Watch Neg/-- U.K.

CE Electric U.K. Funding Co. BBB-/Positive/A-3 U.K.

Centrica PLC A/Negative/A-1 U.K.

CEZ a.s. A-/Stable/-- Czech Republic

C.N. Transelectrica S.A. BB+/Positive/-- Romania

Delta N.V. A-/Negative/-- The Netherlands

DONG Energy A/S BBB+/Positive/A-2 Denmark

Drax Power Ltd. BBB-/Stable/-- U.K.

Dwr Cymru (Financing) Ltd. Secured bank loan A-; senior secured guaranteed AAA; senior secured A-; U.K.subordinated BBB

E.ON AG A/Stable/A-1 Germany

E.ON Sverige AB A/Stable/A-1 Sweden

E.ON U.K. PLC A-/Stable/A-2 U.K.

Edison SpA BBB+/Positive/A-2 Italy

EDP - Energias de Portugal, S.A. A-/Negative/A-2 Portugal

Eesti Energia AS A-/Negative/-- Estonia

Electricite de France S.A. AA-/Stable/A-1+ France

EDF Energy PLC A/Stable/A-1 U.K.

RTE EDF Transport S.A. AA-/Stable/A-1+ France

Elia System Operator S.A./N.V. A-/Stable/A-2 Belgium

Enagas S.A. AA-/Stable/A-1+ Spain

EnBW Energie Baden-Wuerttemberg AG A-/Stable/A-2 Germany

Endesa S.A. A/Watch Neg/A-1 Spain

ENECO Holding N.V. A/Negative/A-1 The Netherlands

Enel SpA A/Watch Neg/A-1 Italy

Enemalta Corp. BBB+/Stable/-- Malta

Energie AG Oberoesterreich A+/Negative/-- Austria

Energie Steiermark AG A/Positive/-- Austria

Energinet.dk SOV AA+/Stable/A-1+ Denmark

ESKOM Holdings Ltd. Foreign currency BBB+/Stable/-- South Africa

Essent N.V. A+/Negative/A-1 The Netherlands

EVN AG A/Stable/-- Austria

EWE AG A/Negative/-- Germany

Federal Grid Co. of the Unified Energy System BB+/Watch Pos/-- Russia

Fingrid Oyj A+/Stable/A-1 Finland

Fortum Oyj A-/Stable/A-2 Finland

Gas Natural SDG, S.A. A+/Negative/A-1 Spain

Gaz de France S.A. AA-/Watch Neg/A-1+ France

Hera SpA A/Stable/A-1 Italy

Hrvatska Elektroprivreda d.d. BBB/Stable/-- Croatia

Iberdrola S.A. A/Watch Neg/A-1 Spain

Irkutskenergo, AO EiE B+/Positive/-- Russia*At Nov. 8, 2007. All ratings are issuer credit ratings unless otherwise stated.

Standard & Poor's Infrastructure Finance Ratings


RATINGS LIST

RATINGS LIST

Utilities


Israel Electric Corp. Ltd. BBB+/Negative/-- Israel

Kazakhstan Electricity Grid Operating Co. (JSC) BB+/Stable/-- Kazakhstan

KazTransGas BB/Stable/-- Kazakhstan

KazTransOil BB+/Positive/-- Kazakhstan

KELAG AG A+/Negative/-- Austria

Kelda Group PLC A-/Stable/A-2 U.K.

Landsvirkjun Foreign currency A+/Negative/A-1 Iceland

Lietuvos Energija A-/Negative/A-2 Lithuania

Lunds Energikoncernen AB (publ) BBB+/Stable/A-2 Sweden

Mosenergo (AO) BB/Stable/-- Russia

N.V. Nederlandse Gasunie AA+/Stable/A-1+ The Netherlands

N.V. NUON A+/Negative/A-1 The Netherlands

National Central Cooling Co. PJSC BBB-/Stable/-- United Arab Emirates

National Grid PLC A-/Stable/A-2 U.K.

Natsionalna Elektricheska Kompania EAD BB/Developing/-- Bulgaria

Northern Gas Networks Holdings Ltd. BBB+/Stable/-- U.K.

Northumbrian Water Ltd. BBB+/Stable/-- U.K.

Polish Oil and Gas Co. BBB+/Stable/-- Poland

Public Power Corp. S.A. BBB+/Stable/-- Greece

Rand Water Foreign currency BBB+/Stable/-- South Africa

RAO UES of Russia BB/Watch Pos/-- Russia

Red Electrica de Espana S.A. AA-/Stable/A-1+ Spain

RWE AG A+/Negative/A-1 Germany

Saudi Electric Co. AA-/Stable/-- Saudi Arabia

S.C. Hidroelectrica S.A. BB/Positive/-- Romania

Scotland Gas Networks PLC BBB/Positive/-- U.K.

Southern Gas Networks PLC BBB/Positive/-- U.K.

Scottish and Southern Energy PLC A+/Stable/A-1 U.K.

Scottish Power PLC A-/Watch Neg/A-2 U.K.

Severn Trent PLC A/Stable/A-1 U.K.

Sociedad General de Aguas de Barcelona S.A. A/Stable/A-1 Spain

South East Water (Finance) Ltd. Senior secured guaranteed AAA; senior secured BBB U.K.

South Staffordshire PLC A-/Watch Neg/A-2 U.K.

Southern Water Services Ltd. Bank loan A- U.K.

S.N.T.G.N. Transgaz S.A. Medias BB+/Positive/-- Romania

Statkraft AS BBB+/Stable/A-2 Norway

Statnett SF AA/Stable/A-1+ Norway

Suez S.A. A-/Watch Pos/A-2 France

Sutton and East Surrey Water PLC BBB+/Stable/-- U.K.

Tekniska Verken i Linkoeping AB A-/Stable/A-2 Sweden

Terna SpA AA-/Stable/A-1+ Italy

Thames Water Utilities Ltd. BBB+/Watch Neg/-- U.K.

Union Fenosa S.A. BBB+/Stable/A-2 Spain

United Utilities PLC A/Watch Neg/A-1 U.K.

Vattenfall AB A-/Stable/A-2 Sweden

Veolia Environnement S.A. BBB+/Stable/A-2 France

Vodokanal St. Petersburg BB+/Positive/B Russia

Three Valleys Water PLC A-/Stable/-- U.K.

Verbundgesellschaft (Oesterreichische Elektrizitaetswirtschafts Aktiengesellschaft) A/Stable/-- Austria

Wasser und Gas Westfalen GmbH BBB+/Stable/-- Germany

Wessex Water Services Ltd. BBB+/Stable/-- U.K.

Western Power Distribution Holdings Ltd. BBB-/Stable/A-3 U.K.*At Nov. 8, 2007. All ratings are issuer credit ratings unless otherwise stated.


RATINGS LIST



Transportation Infrastructure


Abertis Infraestructuras S.A. A/Negative/-- Spain

Aeroporti di Roma SpA BBB/Watch Neg/A-2 Italy

Aeroports de Paris AA-/Stable/-- France

Angel Trains Ltd. A/Negative/A-2 U.K.

Atlantia SpA A/Negative/A-1 Italy

BAA Ltd. BBB+/Watch Neg/NR U.K.

Birmingham Airport Holdings Ltd. A-/Stable/A-2 U.K.

BRISA Auto-Estradas de Portugal S.A. A/Watch Neg/A-1 Portugal

Brussels International Airport Co. BBB/Stable/-- Belgium

Caisse Nationale des Autoroutes AAA/Stable/-- France

CFR Marfa S.A. B-/Watch Neg/-- Romania

CFR S.A. BB/Negative/-- Romania

Cofiroute BBB+/Negative/A-2 France

Copenhagen Airports A/S BBB+/Stable/-- Denmark

Deutsche Bahn AG AA/Negative/A-1+ Germany

DFS Deutsche Flugsicherung GmbH AAA/Negative/A-1+ Germany

DP World Ltd. A+/Stable/A-1 Dubai

Dublin Airport Authority PLC A/Negative/A-1 Ireland

Fjellinjen AS AA/Stable/-- Norway

Hutchison Ports (U.K.) Ltd. A-/Stable/A-2 U.K.

INFRABEL AA+/Stable/A-1+ Belgium

Kazakhstan Temir Zholy BB+/Stable/-- Kazakhstan

Macquarie Airports Copenhagen Holdings ApS BBB+/Stable/-- Denmark

Macquarie Motorways Group Ltd. BBB/Stable/-- U.K.

Manchester Airport Group PLC (The) A/Stable/-- U.K.

N.V. Luchthaven Schiphol AA-/Negative/-- The Netherlands

NATS (En-Route) PLC A/Stable/-- U.K.

Network Rail Infrastructure Finance PLC Senior secured debt AAA U.K.

Network Rail MTN Finance PLC Senior secured debt AAA U.K.

Norges Statsbaner AS AA/Stable/A-1+ Norway

NS Groep N.V. AA/Stable/-- The Netherlands

Oresundsbro Konsortiet Senior unsecured debt AAA Denmark

Rede Ferroviaria Nacional REFER, E.P. A/Stable/-- Portugal

Reseau Ferre de France AAA/Stable/A-1+ France

Russian Railways (JSC) BBB+/Stable/-- Russia

Societe Nationale des Chemins de Fer Belges Holding AA+/Stable/A-1+ Belgium

Societe Nationale des Chemins de Fer Francais AAA/Stable/A-1+ France

Transnet Ltd. Foreign currency BBB+/Stable/-- South Africa

Unique (Flughafen Zurich AG) BBB+/Stable/-- Switzerland

VINCI S.A. BBB+/Negative/A-2 France

West Coast Train Finance PLC Senior secured debt A/Stable U.K.*At Nov. 8, 2007. All ratings are issuer credit ratings unless otherwise stated.

RATINGS LIST


RATINGS LIST


Project Finance

Name Issue credit rating* Country

Abu Dhabi National Energy Company PJSC (TAQA) AA-/Stable/A-1+ (issuer credit rating) United Arab Emirates

Ajman Sewerage (Private) Co. Ltd. AAA (insured); BBB (SPUR)/Stable United Arab Emirates

Alpha Schools (Highland) Project PLC AAA (insured); BBB (SPUR)/Stable U.K.

Alte Liebe 1 Ltd. AAA (insured); BBB- (SPUR)/Stable Channel Islands

Aspire Defence Finance PLC AAA (insured); BBB- (SPUR)/Stable U.K.

Autolink Concessionaires (M6) PLC AAA (insured); BBB+ (SPUR)/Stable U.K.

Autoroutes Paris-Rhin-Rhone Senior unsecured bank loan, term loan BBB-/Stable; Francesenior unsecured MTN BBB

Autovia del Camino S.A. AAA (insured); BBB (SPUR)/Stable Spain

Bina-Istra, d.d. Senior secured debt BBB-/Stable Croatia

Breeze Finance S.A. Senior secured debt AAA (insured), BBB (SPUR)/Stable; Luxembourgsubordinated debt BB-/Stable (preliminary)

Capital Hospitals (Issuer) PLC AAA (insured); BBB- (SPUR)/Stable U.K.

Catalyst Healthcare (Manchester) Financing PLC AAA (insured); BBB (SPUR)/Negative U.K.

Catalyst Healthcare (Romford) Financing PLC AAA (insured); BBB (SPUR)/Stable U.K.

Central Nottinghamshire Hospitals PLC AAA (insured); BBB (SPUR)/Stable U.K.

Consort Healthcare (Birmingham) Funding PLC AAA (insured); BBB- (SPUR)/Stable U.K.

Consort Healthcare (Mid Yorkshire) Funding PLC AAA (insured); BBB- (SPUR)/Stable (preliminary) U.K.

Consort Healthcare (Salford) PLC AAA (insured); BBB (SPUR)/Stable (preliminary) U.K.

Consort Healthcare (Tameside) PLC AAA (insured); BBB (SPUR)/Stable (preliminary) U.K.

CountyRoute (A130) PLC Senior secured debt BBB/Stable; subordinated debt BB/Stable U.K.

Coventry & Rugby Hospital Co. PLC (The) AAA (insured); BBB (SPUR)/Stable U.K.

CRC Breeze Finance S.A. Senior secured debt BBB/Stable; subordinated debt BB+/Stable Luxembourg

CTRL Section 1 Finance Class A1 and A2 debt AAA U.K.

Delek & Avner - Yam Tethys Ltd. Senior secured debt BBB-/Stable Israel

DirectRoute (Limerick) Finance Ltd. AAA (insured); BBB- (SPUR)/Stable (preliminary) Ireland

Discovery Education PLC AAA (insured); BBB- (SPUR)/Stable U.K.

Education Support Enfield Ltd. Senior secured bank loan A/Stable U.K.

Exchequer Partnership (no. 1) PLC Senior secured debt AAA (insured) U.K.

Exchequer Partnership (no. 2) PLC AAA (insured); BBB+ (SPUR)/Stable U.K.

Fixed-Link Finance B.V. G1 and G2 notes: AAA; junior subordinated class C notes: The NetherlandsC/Negative; senior secured class A notes and subordinated class B notes: AAA/Stable

Health Management (Carlisle) PLC Senior secured debt AAA (insured) U.K.

Healthcare Support (Newcastle) Finance PLC AAA (insured); BBB- (SPUR)/Stable U.K.

Healthcare Support (North Staffs) Finance PLC AAA (insured); BBB- (SPUR)/Stable (preliminary) U.K.

Highway Management (City) Finance PLC AAA (insured); BBB (SPUR)/Stable U.K.

Hospital Co. (Swindon & Marlborough) Ltd. (The) AAA (insured); BBB+ (SPUR)/Stable Channel Islands

InspirED Education (South Lanarkshire) PLC AAA (insured); BBB- (SPUR)/Watch Neg U.K.

Integrated Accommodation Services PLC AAA (insured); A (SPUR)/Stable U.K.

International Power PLC BB-/Stable/-- (issuer credit rating) U.K.

M6 Duna Autopalya Koncessios Zartkoruen Mukodo Eszvenytarsasag Senior secured bank loan and debt AAA Hungary

Max Two Ltd. Senior secured debt BBB-/Negative Channel Islands

Metronet Rail BCV Finance PLC and Metronet Rail SSL Finance PLC Senior secured bank loan BB+/Watch Neg; senior secured U.K.debt AAA, BB+(SPUR)/Watch Neg

Nakilat Inc. A+/Stable/-- (issuer credit rating) Marshall Islands

NewHospitals (St. Helens and Knowsley) Finance PLC AAA (insured); BBB (SPUR)/Stable U.K.

Octagon Healthcare Funding PLC AAA (insured); BBB (SPUR)/Stable U.K.

Peterborough (Progress Health) PLC AAA (insured); BBB- (SPUR)/Stable (preliminary) U.K.

Premier Transmission Financing PLC AAA (insured); A (SPUR)/Stable U.K.

Ras Laffan Liquefied Natural Gas Co. AAA (insured); A/Stable Qatar

*At Nov. 9, 2007. All ratings are issue ratings unless otherwise stated.



Project Finance

Name Issue credit rating* Country

Ras Laffan Liquefied Natural Gas Co. Ltd. (II) and Senior secured debt A/Stable QatarRas Laffan Liquefied Natural Gas Co. Ltd. (3)

RMPA Services PLC AAA (insured); BBB- (SPUR)/Positive U.K.

Road Management Consolidated PLC AAA (insured); BBB (SPUR)/Stable U.K.

Services Support (Manchester) Ltd. Senior secured bank loan BBB/Stable U.K.

Société Marseillaise du Tunnel Prado-Carénage (SMTPC) Senior secured bank loan AAA (insured) France

Sutton Bridge Financing Ltd. Senior secured debt BBB-/Stable U.K.

TAQA North Ltd. Senior unsecured debt AA- United Arab Emirates

THPA Finance Ltd. Class A2 debt A; class B debt BBB; class B debt BB U.K.

Transform Schools (North Lanarkshire) Funding PLC AAA (insured); BBB- (SPUR)/Stable U.K.

Tube Lines (Finance) PLC Senior secured bank loan AAA/Stable (insured); senior secured U.K.B notes BBB/Stable; senior secured A-1 notes AA/Stable; subordinated C notes BBB-/Stable; subordinated D notes BB/Stable

Walsall Hospital Co. PLC (The) AAA (insured); BBB- (SPUR)/Stable (preliminary) U.K.*At Nov. 9, 2007. All ratings are issue ratings unless otherwise stated.


RATINGS LIST

CONTACTS

LondonMichael WilkinsManaging DirectorHead of Infrastructure Finance Ratings(44) [email protected]

Peter KernanManaging Director and Team Leader European Utilities(44) [email protected]

Jonathan ManleySenior Director and Co-Team LeaderProject Finance and Transportation Infrastructure (44) [email protected]

Lidia PolakovicSenior Director and Co-Team LeaderProject Finance and Transportation Infrastructure (44) [email protected]

Paul LundDirector and Team LeaderCorporate Securitization (44) [email protected]

Elif AcarDirector(44) [email protected]

Vincent AllilaireDirector (44) [email protected]

Mark Davidson Director(44) 20-7176-6306 [email protected]

Maria LemosDirector(44) [email protected]

Karim NassifAssociate Director (44) [email protected]

Olli RouhiainenAssociate Director (44) [email protected]

Beata Sperling-TylerAssociate Director(44) [email protected]

Beatrice de TaisneAssociate(44) [email protected]

Karin ErlanderAssociate(44) 20-7176-3584 [email protected]

Amrit GescherAssociate(44) [email protected]

James Hoskins Associate(44) 20-7176-3393 [email protected]

Tania TsonevaRatings Specialist(44) [email protected]

Florian de ChaisemartinRatings Analyst(44) [email protected]

Terence SmiyanResearch Assistant(44) [email protected]


KEY ANALYTICAL CONTACTS

KEY ANALYTICAL CONTACTS

CONTACTS

FrankfurtRalf EtzelmuellerAssociate Director(49) [email protected]

Timon BinderRatings Specialist(49) [email protected]

Ekaterina LebedevaSenior Research Assistant(49) [email protected]

MadridAna NogalesDirector(34) [email protected]

Jose Ramon Abos Associate Director(34) 91-389-6962 [email protected]

ParisHugues de la PresleDirector(33) [email protected]

Alexandre de LestrangeDirector(33) [email protected]

StockholmMark SchindeleAssociate(46) [email protected]

MilanMonica MarianiDirector(39) [email protected]

MoscowEugene KorovinAssociate Director (7) [email protected]

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IFR1107

European Infrastructure Finance Yearbook - SP

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