‘Projects with stable cash flows ideal for debt market'

Will the recent budget proposal of hiking FII limit in infrastructure help the funding gap in the sector? We posed this question to Mr S. Nandakumar, Senior Director & Global Infrastructure & Project Finance Group, Fitch Ratings. Welcoming the move, Mr Nandakumar states that infrastructure projects that achieve completion and move to stable operating profiles can see an upward ratings migration that would aid refinancing bank debt with bond issues. He also provides his view on the slowdown in road projects and the increasing trend of producers coming up with merchant power projects.

Excerpts from the interview:

Do you believe the hike in FII limit in infrastructure bonds could help bridge the funding gap in the sector?

Given the enormous infrastructure funding India needs, any step that is designed to potentially increase supply of capital is welcome although the incremental availability, due to the increase in the ceiling, may itself constitute a small proportion of the total requirement. Also, it is worth examining if the existing limits are fully utilised by the sector.

We have not seen too many infrastructure players tap corporate bonds. Will this change?

Projects/SPVs with a track record of generating stable operating cash flows tend to be ideally suited to the debt capital markets. For example, operating road (annuity/toll) projects, built, under a concession from NHAI, could be potential candidates for floating bonds.

Developers have not enjoyed high credit standing in the past? Would they be able to tap the bond/debt fund channel effectively?

Ratings of infrastructure projects would reflect the level of risk associated with each project. As majority of projects are currently in the construction phase, ratings tend to be lower, given the high levels of completion risk that one has come to witness in them. However, as projects achieve completion and stable operating profiles, there can be an upward ratings migration that sets them up for refinancing bank debt with bond issues. Also, remember that the Indian bond markets seem to have an appetite only for very highly rated bonds.

Despite budgetary allocation, what has resulted in slower pace of order flow especially in the road segment?

The pace of new projects coming into the market is a function of government policy. Some of the things such as land acquisition issues, the ever-changing model concession agreements are giving it an unsettled look. This, in combination with a more challenging financing environment and the fact that new norms do not allow developers to bid for new projects if they have not financially closed three or more existing projects, have caused a slowdown in new projects coming into the market.

Have toll road projects become less riskier for developers over the years?

Not necessarily. Given the limited history of private participation in toll road in India, traffic estimations still remain in the nascent stages. Even in more developed markets, certain amount of inconsistency and inaccuracy is a given. It is no different in India, but, considering the kind of aggressive bids that toll developers have been putting in, you would almost expect that their forecast to be ambitious and eventually, when they become operational, the actual may not be close to the forecast. So, underperformance in terms of original forecast does continue.

With more private utilities taking the merchant power route and given the volatile merchant power prices, is this segment becoming more risky?

It is accepted wisdom that merchant power plants are inherently risky than those that have long-term firm contracts for offtake. Over a 15-20 year period, merchant power prices could move in different directions, causing volatility and cash flow uncertainty. However, an independent power producer may have certain cost advantages. The advantage could come from any number of reasons — low capital cost or low financing and, importantly, when fuel cost is low. If you have imported coal with no long-term supply assurance, clearly, not only will cost be higher, it would be more volatile too. Even if you take a market with only PPAs, in the merit order dispensation, the electric utilities would prefer producers with a more competitive tariff. Similarly, even if you are selling power through the merchant route, being competitive on the cost side will give you better margins and superior ability to withstand stress even if merchant prices continue to drop.

Also bear in mind, notwithstanding these capacity additions, we are still going to be a power-deficit country. There is a minimum cost of production for utilities. It is after all a commodity. So the selling price eventually should have some relationship to the mean of cost production across the industry and that isn't going to fall anytime.

Would profits of power producers take a hit due to volatile merchant power prices?

What is likely to decline is the super-normal profit that people were making through the merchant power pricing route when they were ruling at Rs 6 or Rs 7. That may not be sustainable over a length of time. But if you ask me whether Rs 3.5-4 is sustainable- then surely yes, because you would not have too many producers who are able to produce at rates substantially below; say Rs 2. Maybe the older plants which are fully depreciated may be able to do so but the marginal production that comes in to markets will not happen at such low levels.

So you will have some base level of tariffs and as long as your power production costs are below that you will still make a margin to service your debt and make a reasonable return on your equity. Getting 30 or 40 per cent IRRs are clearly not sustainable because of the fresh capacities coming in. In the last three years merchant prices have been steadily falling and state electricity boards are themselves not in the best of financial health.

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