How Asset Essentiality, Market Position and Replacement Dynamics Influence Credit Ratings
BY Nicole Markou
Consider asset strength, market position, replacement costs in credit analysis
Conventional project finance thinking suggests that a project’s credit quality should not exceed the credit quality of the entity responsible for its revenues. Yet some project credit ratings indicate a more complicated reality: Assets sometimes prove more resilient than the counterparties that support them.
The global methodology for rating project finance used by Morningstar DBRS recognizes that, in certain circumstances, a project’s intrinsic assessment may be higher than a revenue counterparty’s assessment. Important considerations can include the asset’s essentiality, the likelihood that a replacement counterparty could be secured if a contractual relationship were disrupted, and the asset’s broader market position and ability to generate revenues independent of the existing contract.
As a result, while counterparty credit quality remains a fundamental consideration, it is not always the sole determinant of project risk. The underlying asset’s resilience and the extent to which its cash flows can survive or adapt to contractual disruption may support a stronger credit rating outcome than a strict linkage to the counterparty’s credit profile would suggest.
Project finance credit ratings can reflect asset essentiality, market position and replacement counterparties in addition to the credit quality of the current revenue counterparty.
Essential Assets Are Hard to Walk Away From
We generally consider an asset to be essential when we believe that, even in a bankruptcy scenario, the underlying contract would continue to be honored and payments under the project would continue. Some assets perform functions that are critical to the operation of larger systems, networks or industrial processes, or to a corporation’s core business operations. When an asset occupies such a position, the economic and operational consequences of losing access to it can be significant. As a result, customers, regulators, lenders, operators and other stakeholders often have strong incentives to preserve the asset’s functionality and maintain the associated flow of services and revenues throughout a restructuring process.
Clover Limited Partnership (Clover), which Morningstar rates, provides a relevant example. When Pacific Gas and Electric Company (PG&E), an offtaker for one of the renewable projects in Clover’s portfolio, filed for chapter 11 protection in January 2019, the project continued to receive payments under its 20-year, fixed-price renewable energy credit agreement. Following PG&E’s emergence from bankruptcy in July 2020, the risk that the agreement could be renegotiated or disclaimed was significantly reduced. This illustrates how contracted project cash flows may continue during an offtaker’s restructuring.
From a credit perspective, this may mitigate concerns that contractual obligations could cease to be honored during periods of financial stress. Where an asset is viewed as essential, the likelihood of ongoing cash flow generation may be greater than a stand-alone assessment of the counterparty’s credit profile would otherwise imply. This may be particularly true where stakeholders have strong incentives to preserve contractual arrangements and associated cash flows through a restructuring or insolvency process.
While every transaction must be assessed on its own merits, asset essentiality can be a meaningful consideration in the overall credit analysis and may support credit outcomes beyond those suggested by a stand-alone assessment of counterparty credit quality.
The Importance of Replacement Counterparties
A useful stress test in project finance is to ask a simple question: What happens to the project if the current counterparty is no longer able or willing to perform its obligations?
In some transactions, the answer may be concerning. If a project is highly dependent on a single customer and has limited alternative uses, the loss of that relationship could significantly impair cash flows. In other cases, however, the asset may continue to retain substantial value because other users would be willing and able to use its services.
The ability to secure a replacement counterparty can be an important source of credit strength. Where demand for the project’s services remains strong and alternative customers are available, the loss of a single contractual relationship may not necessarily result in a permanent impairment of cash flows. In such cases, the analysis may extend beyond the current counterparty and consider the likelihood that another customer could use the asset’s services. For example, assets serving large and diverse markets may have stronger replacement prospects than assets developed solely for a single customer’s needs.
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Market Position Can Outlast a Contract
In some cases, the asset itself may occupy a sufficiently strong competitive position that it could continue generating meaningful revenues even without the existing contractual arrangement. Renewable energy projects in markets with strong renewable procurement requirements provide a useful illustration. In jurisdictions where utilities and other load-serving entities face long-term clean energy mandates, demand for renewable generation may remain robust even if an individual contractual relationship is disrupted.
In such circumstances, the analysis may consider not only the current contract but also the broader market demand for the project’s output and its ability to generate revenues absent that specific contractual arrangement. Where demand for the asset’s output remains strong, there may be a reasonable basis to expect that alternative commercial arrangements could be secured over time. At the same time, where an established market already exists for the asset’s output, the loss of a contracted counterparty may not necessarily interrupt cash flow generation but instead result in the project operating on a merchant basis. As a result, the analysis may consider both the likelihood of future contracting opportunities and the asset’s ability to remain economically viable under merchant market conditions.
The Asset Behind the Credit Rating
Ultimately, project finance credit ratings are not only assessments of who pays today, but also of what remains if that relationship breaks down. In certain circumstances, the durability of an asset’s economic value may prove more important than the current counterparty’s credit quality. Nevertheless, any credit rating benefit associated with asset essentiality or replaceability is reserved for circumstances where there is strong and observable evidence that project cash flows would continue following the loss of the existing counterparty or contractual arrangement. Such conclusions require a rigorous assessment of the asset’s characteristics, market dynamics and alternative sources of revenue, and each case must be evaluated based on its specific facts and circumstances.
Nicole Markou is a senior vice president at Morningstar DBRS with over 20 years of experience in credit analysis spanning the rating agency and banking sectors, with a primary emphasis on energy. Prior to joining Morningstar DBRS, she spent 14 years at Fitch Ratings, where she led analytical coverage across project finance, digital infrastructure, public power and municipal structured finance. For more information, visit morningstar.com.