Market participants have recently been questioning whether project finance transactions can have a higher rating than that on the respective sovereign, particularly in low- and middle-income countries. Although S&P Global Ratings can rate project finance transactions above the level of the sovereign foreign currency rating, it is uncommon. This is because of the nature of the contracts in project finance, which can't always anticipate the country-specific circumstances that will unfold when a sovereign is under financial stress.

We define project finance as a method of financing certain capital-intensive assets, mostly in the infrastructure and industrial sectors. Examples are toll roads, power plants, oil and gas production or midstream assets, as well as airports and ports. Project finance transactions involve one or more limited-purpose entities that together undertake the construction and/or operation of an asset or set of assets.

What We Look For When Rating Project Finance Transactions

We look for seven critical attributes when rating debt under our project finance methodology (see table 1 and "General Project Finance Rating Methodology," published on Dec. 14, 2022).

Table 1

As a general principle, we do not need to constrain all the ratings in a given country at the level of the sovereign rating. This is because a sovereign default does not imply that every entity in the country will default as well, judging by historical default patterns after sovereign defaults. Therefore, our methodology does not include a ceiling on other in-country ratings (colloquially known as a sovereign ceiling). This principle applies to project finance transactions as well.

Nevertheless, our methodology does reflect the likely effect of the economic conditions while a sovereign is under financial stress on the entities in that country. The economic stress that has accompanied sovereign defaults is severe, and it has typically led to a significant increase in nonsovereign defaults.

The economic conditions in a country in which the sovereign is either likely to default, or has defaulted, tend to be complex, fast-moving, and stressful, and these conditions are typically associated with significantly higher default risk for the entities in the country.

In our methodology, we reflect the linkage between the general environment in a country whose sovereign is experiencing credit stress, and the project's ability to withstand those conditions, in an assessment of the distance between the project's credit quality and that of the sovereign.

When We Rate A Project Finance Transaction Above The Sovereign

We can rate a transaction above the sovereign foreign currency rating if, in our view, there is an appreciable likelihood that the transaction would not default if the sovereign were to default. To evaluate that likelihood, we simulate a sovereign stress scenario when determining the rating on entities in a given jurisdiction.

We can rate entities that pass such a stress test up to two or four notches above the sovereign foreign currency rating, depending on whether we view their sector's sensitivity to country risk as moderate or high, respectively. Our rating methodology describes the steps that we follow, including the different approaches we take depending on the sovereign's credit quality (see "Ratings Above The Sovereign--Corporate And Government Ratings: Methodology And Assumptions," published Nov. 19, 2013).

An additional element that can constrain our ability to rate a project finance transaction above the sovereign foreign currency rating is our assessment of transfer and convertibility (T&C) risk. This risk is particularly relevant for lowly rated sovereigns, including some low- and middle-income countries.

The T&C assessment reflects our view of the likelihood of a sovereign restricting a project's access to foreign currency, thereby preventing it from transferring that currency to creditors to service the rated debt. Even if we expected a transaction to generate enough local currency under a sovereign stress scenario to buy the foreign currency to service the debt, our view of whether the sovereign would impose T&C restrictions in a default scenario could constrain our ability to rate the project higher than the sovereign foreign currency rating. This is why many emerging-market project finance transactions include structural features that aim to offset T&C risk.

Project Finance Contract Limitations

Project finance is a type of financial engineering that involves multiple contracts that allocate risk among the different transaction participants and establish what is expected and permitted of each of them. These contracts provide a certain degree of visibility on the cash flows that will constitute the source of debt repayment. Ultimately, the repayment of the debt relies on the fulfilment of the obligations under the different contracts.

However, the contracts are drafted with knowledge and understanding of the past, but limited visibility on the future general and economic conditions within the jurisdiction. This is why project finance is vulnerable to the unexpected and volatile conditions that may arise in times of sovereign credit stress.

The contracts cannot anticipate all possible scenarios, and the scope to make changes quickly is limited in practical terms. The more parties to a contract, the harder it is to bring them all to the table to agree new contractual conditions, particularly if the level of economic uncertainty is higher than usual. Even with a small number of parties, the ability to make timely changes tends to be limited.

Another issue is the fact that governments can change the laws governing the contracts. Some contracts may include change-in-law provisions, but even by changing minor aspects of the regulations, governments can alter the operating conditions--and thereby potentially the credit quality--of the underlying assets that are part of the project finance transaction. For example, in an effort to reduce the impact of inflationary pressures, governments can limit tariff adjustments. Even if it was possible to file a claim against such an action, its resolution might take time.

In an attempt to mitigate this risk, some contracts are governed by the law of a country that may be seen as having a stronger legal system (for example, the U.K. or the U.S.) than a low- or middle-income country. Although this allows creditors to petition under a legal system that has a greater degree of predictability in defending creditors' rights, our assessment of the transaction's credit quality not only considers the contracts, but also the operating assets and their location in the low- or middle-income country.

It can be extremely challenging to enforce the ruling of a foreign court in the country where the assets are located. Situations involving multiple assets in multiple countries are even more complicated. In all cases, even when it is theoretically possible for us to rate a transaction above the sovereign, practically it is impossible to eliminate all the potential consequences of a sovereign default, and so the relevant sovereign rating does influence the project rating. The risk that one or more sovereigns will add to a transaction will therefore always require a case-by-case analysis and will depend on the structure and the underlying credit quality of the relevant sovereign(s).

We Rate A Low Proportion Of Transactions Above The Sovereign

We rate 11 transactions, or less than 4% of the overall rated portfolio, above the relevant sovereign foreign currency rating as of June 28, 2024 (see table 2). Nine of these 11 transactions have unconditional and irrevocable guarantees that result in the full substitution of the transaction's underlying credit quality for that of the guarantor. We rate two projects above the relevant sovereign for underlying structural reasons rather than credit substitution reasons.

Table 2

Around 95% of the rated portfolio are projects located in countries that we rate investment grade, that is, 'BBB-' or higher (see chart 1). As a result, it is hard to draw conclusions from this data for projects in jurisdictions that we rate speculative grade, that is, 'BB+' or lower.

Chart 1

Generally, there is a gap between a project's underlying credit quality and the sovereign rating

We assess a project's underlying credit quality by excluding government support or guarantees. From this perspective, almost 90% of the transactions have lower ratings than the relevant sovereign rating, with an average gap of more than six notches, or two rating categories (see chart 2). This is unsurprising, because project finance transactions are typically structured to achieve low investment-grade, or 'BBB' category, ratings. Moreover, close to 70% of the portfolio have assets in the U.S., Canada, the U.K., Australia, and countries in Western Europe, which generally have ratings in the 'AA' category.

Chart 2

Excluding the projects we rate in these countries, the remaining 60 projects have average underlying credit quality of over four notches, or one rating category, below the relevant sovereign rating (see charts 3 and 4). The outcome would not change materially if we included projects with underlying credit quality that is on a par with that of the relevant sovereign.

These conclusions show general trends only. In addition, sovereign credit quality could also influence some transaction counterparties that cap the project's underlying credit quality.

Chart 3

Chart 4

For projects with underlying credit quality higher than that of the sovereign, but that we do not rate as such, the assets are in Latin America and the Caribbean. Most are transport- and power-related projects with significant regulatory influence over their tolls, tariffs, or revenues. This helps explain the rating limitation. The median gap between the underlying credit quality of the project and the relevant sovereign rating is two notches.

No Sovereign Rating Ceiling

Although we can rate project finance transactions above the sovereign rating with no inherent ceiling, we consider a number of factors when assessing projects' creditworthiness beyond sovereign levels. These include the economic conditions that could affect all the rated entities in a country experiencing severe financial distress following a sovereign default, a situation that is likely to be characterized by complex and rapidly changing circumstances. T&C risk is therefore a critical part of our analysis and could limit our ability to rate project finance transactions above the sovereign.

We only rate 11 project finance transactions above the relevant sovereign, and in most of these cases, this is due to guarantees that result in credit substitution. Moreover, most of the transactions are in developed and highly rated sovereigns, making it hard to draw conclusions for lowly rated sovereigns or for low- and middle-income countries.