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August 2006
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Consistent with existing practice, the proposed methodology separately considers risks in the construction and operations phases of PFI / PPP projects. As a result, should projects be structured with a significantly higher risk profile in construction than in operations, Moody's ratings on those projects, post-construction, will adjust to reflect a successful transition to project operations. Moody's will comment on its opinion of the relative risk of the construction and operations phases of new PFI / PPP projects as ratings are assigned. A beta test version of the construction simulation model will shortly be available to market participants at no cost on execution of a usage agreement. For further information on how to obtain the model, please contact Grant Headrick in Moodys Toronto office at grant.headrick@moodys.com.
Table of Contents
What is PFI / PPP? .......................................................................................................................... 4 About this Rating Methodology ....................................................................................................... 4
Methodology Overview ...........................................................................................................................5
Liquidity ....................................................................................................................................... 25 Ratings after the Transition to Operations ..................................................................................... 26 Appendix A: Project Complexity Definitions ................................................................................... 27 Appendix B: Typical Performance Supports ................................................................................... 28 Appendix C: Technical Information about the Model ...................................................................... 29
1. The current approach to assessing construction risk for financings rated on the U.S. Municipal Bond Rating Scale is outlined in "Construction Risk: Mitigation Strategies for U.S. Public Finance", Moody's Special Comment, December 2004 2. "Request for Comment: Mapping of Moody's U.S. Municipal Bond Rating Scale to Moody's Corporate Rating Scale and Assignment of Corporate Equivalent Ratings to Municipal Obligations" Moody's Special Comment, June 2006
METHODOLOGY OVERVIEW
In this report we will describe each of the components of a construction project in terms of its default and recovery characteristics and its correlation with the other project elements. The expected loss - and therefore the credit risk - of the project is based on a Monte Carlo simulation of each of the project's components. To obtain a final rating, the result from a large number of simulations is overlaid with a series of qualitative factors that reflect each project's unique characteristics. This report is divided into three main sections as follows:
3.
4. 5. 6. 7.
The concession agreement and its schedules also define all of the operational parameters of the project including the responsibilities of the concessionaire, performance standards, hand-back requirements, etc. Discussion of Moody's proposed approach to rating PFI / PPP projects during the operating period will be the subject of a forthcoming request for comment. Also known as the "long-stop date". As well as any external credit supports that have been put in place for such a purpose. Either directly, via a formula payout, or indirectly through a market tender mechanism. Other termination scenarios in PFI / PPP transactions are possible. As an example, the government usually reserves the right to terminate the project for convenience. These scenarios are not covered in this report as they usually provide for creditors - or even creditors and equity investors - to be paid out.
Project Company
Operating
Sub Contracts
Construction
Sub Contracts
For example, if the sunset date for construction completion and project acceptance in the CA is 36 months, the sunset date in the DBA may be 3 - 6 months shorter. Similarly, if under the terms of the CA,the Project Company is responsible for the payment of liquidated damages to the Off-taker in a delay scenario, the DBA typically requires that the Contractor be responsible for those payments in addition to any senior debt-service payments that are not otherwise provided for. The difference in performance thresholds is designed to give the Project Company the time to react to construction performance failures and, ultimately, to replace the Contractor and finish the Project with a substitute before the Off-taker can terminate the overall Concession Agreement.
8.
The company contracted to do the construction is typically a subsidiary of one or more construction companies. The subsidiary is often an operating entity in its own right (dedicated, for example to construction in certain region). Multiple contractors may also join together in a (usually) unincorporated joint-venture.
Bank
Project Company
DBA
Construction Company
Insurance Co./Bank
1. Raw Construction Risk
Expressed in credit risk terms, raw construction risk is the expected loss on the stand-alone project. It can be analogized as the potential exposure of the sponsoring government or agency to cost or schedule over-runs for an average project of its type should the project have been let on a cost-plus basis to a contractor of average experience and ability9. As a result, this expected loss does not take into account the willingness or the ability of contractors or other parties to absorb the consequences of cost or schedule over-runs. The level of raw construction risk in a given project is first and foremost a function of the project's complexity. As is discussed below, Moody's has grouped the majority of projects seen in PFI / PPP transactions into four project types for ease of analysis. The four are Standard Buildings, Standard Civil Infrastructure, Complex Buildings and Complex Civil Infrastructure. Recognizing that it is difficult to capture any particular project's complexity given only four categories, Moody's also considers a range of qualitative factors that can influence the amount of raw construction risk. Examples of these factors include the experience of the contractor with the particular type of project being constructed, the degree of reliance on new and/or unproven technologies and the degree to which local economic conditions around the project site will affect the cost and availability of labour and materials over the construction period.
2. Contractor Support
The DBA governing construction in PFI/PPP transactions is typically structured on a fixed-price, fixed term basis. The Contractor is obliged to complete the project, absorb the costs of over-runs and often pay debt service otherwise expected to be covered from operating income as well as any liquidated damages or penalties assessed against the Project Company. While in many cases the obligation is open-ended, the Contractor can often cap its liability at some percentage of the contract amount - particularly the liability to pay liquidated damages to the sponsoring government / agency or Project Company.
9.
The "cost plus" analogy is clearly an imperfect one as cost-plus contracts are also generally at risk of not featuring the same degree of oversight, cost control, etc., by contractors as when the contracting firms are responsible for overages.
Moody's evaluation of the value of contractor support to a transaction incorporates an opinion of both the ability of the contractor to pay as required and its willingness to do so - rather than walk away and face reputation or legal challenges. Importantly, Moody's also considers the impact of the scenario where the Contractor, despite its best intentions, is unable to complete its responsibilities and needs to be replaced. In those circumstances, the project may suffer not only from the time lost while a new contractor is located but also from the likelihood that substitute contractors may charge a premium price to assume a project mid-contract.
5. Equity
The capital structure of the Project Company usually features a tranche of equity ranging from 10% - 20% of the total capitalization which is provided by the project sponsors. Equity provides funding for the project budget and, in the event of a termination, may provide credit support to the project debt by absorbing losses. The elements of construction risk packages can differ significantly across project types and by jurisdiction. Generally, transactions that are wrapped by financial guaranty insurers before funding feature only contractor support and relatively low levels of performance and financial support while those placed directly into the debt markets usually include a high level of financial support (along with contractor and performance support)11. As a termination payment generally provides for the Project Company to receive the contract amount less the cost to complete, the loss severity on a project - after considering the benefits of the construction risk mitigation package and loss absorption by equity - equals the loss on the senior debt.
10. The most common types of performance supports are defined in Appendix B. 11. For example, most PFI / PPP transactions in the UK feature only a modest level (10% - 20% of the construction contract amount) of performance support in the form of adjudication bonds while many Australian transactions have featured full (100% of the debt amount) financial support via bank letters of credit.
Loss suffered by investors as a percentage of par (LS) Amount of budget overage / cost of schedule overage1 Expected Loss = PD*LS
1. Implemented as a probability distribution of different losses / budget and cost over-runs. See Modeling Raw Construction Risk.
Once raw construction risk is translated into its credit risk equivalent, the construction risk package can be expressed as a portfolio of financial assets supporting a financial liability. The asset portfolio is made up of the construction obligation, the contactor's support and any performance or financial supports, while the senior liability to be rated is generally the amount of senior debt to be issued. While it might seem unusual to characterize a construction obligation as a financial asset, one can consider it as a bond that, rather than paying par at maturity, "pays" the project the right to earn the operating period cash-flows. If the construction obligation "defaults", the loss to the project is the amount that the termination payment from the Off-taker will not cover - the cost-to-complete - plus the cost of carry until the termination payment is received. Recognizing that the construction risk package on most PFI / PPP transactions can be viewed as an analogue of a portfolio of financial assets supporting a financial liability - a CDO - Moody's has adapted its widely used CDOROM software, originally designed to assess the credit quality of synthetic CDOs to allow it to be used to assess the credit quality of a construction package.
CDOROM
CDOROM is a Monte Carlo-based simulation model used by Moody's analysts to rate synthetic CDOs. It calculates the expected loss (i.e. the credit risk) for a portfolio of financial assets based on each asset's default probability and recovery rate distribution as well as how each asset's performance is correlated with the others in the portfolio.
10
Contractor support
Commercial contract
11
Moody's review of ultimate recoveries from a sample of approximately 400 US bankruptcies and distressed exchanges of non-financial corporations suggests that historical variation in firm-wide average recovery rates is consistent with a beta distribution for enterprise value bounded between 0% and 120% of liabilities that has a mean of 52% and a standard deviation of 28%16. The chart below presents the same results from the creditors' perspective: the distribution of losses on enterprises' liabilities given default17 .
1.50% Probabilty
1.00%
0.50%
0.00% -20% 0% 20% 40% 60% Loss (%) 80% 100% 120%
In contrast to the relative freedom of corporations in unregulated industries to operate, the structure of construction contracts generally and the structure of design-build agreements in PFI / PPP transactions in particular, tend to limit the amount of cost and schedule over-runs to far below the levels experienced by unsecured creditors of defaulted corporations. This is because: The construction obligation is well defined in advance, has been explicitly priced by the Contractor and generally cannot be altered. The cost of changes to the project requirements after the design has been agreed ("variations") are generally the responsibility of the Off-taker; In most transactions, the Project Company engages a technical advisor that reviews the scope of the construction, the budget sufficiency and the feasibility of the schedule. The Off-taker generally has also done a capability review of the budget, schedule, etc., before awarding the contract to a particular concessionaire; During construction, equity investors in and/or lenders to the project company engage an independent engineer18 to monitor the progress of project and authorize payments to the Contractor. The independent engineer's responsibility is to review completed work, to satisfy itself that the works meets specifications and confirm that the project is on budget and on schedule. The independent engineer is generally not permitted to release funds to the Contractor unless the amounts remaining in the construction account are sufficient to complete the project after considering the work completed to date; and The overwhelming majority of projects subject to PFI / PPP transactions involve design and construction techniques that are well understood and have been repeatedly applied elsewhere. Moody's has determined stressed case loss severity distributions for each project class based on: (i) our existing PFI / PPP ratings, (ii) an internal survey of Moody's project finance analysts globally, and (iii) discussions with major contractors in various jurisdictions.
16. Setting the endpoint of the enterprise value / liability ratio at 120% allows for the (generally low probability) outcome that firm value in default will exceed firm liabilities in order to capture those circumstances in which debt recoveries are so strong that the firm's preferred and common stockholders emerge from bankruptcy with some recoveries. 17. Where Recovery Rate = 1- Loss Given Default. Presented in this form, the mean of the distribution is 48%. Note that since creditors can generally not recover more than they are owed, the LGD distribution is truncated at 0. 18. Also known as an "Independent Certifier".
12
Presented in comparison with the loss-given-default distribution for non-financial corporations cited above, the results for PFI / PPP construction projects are consistent with beta distributions with the following characteristics:
a
Standard Corporate
13
nificant cost over-run, a contractor may be more likely choose to walk away from the contract - and face the subsequent legal and reputation consequences - than to walk away from a comparable bond or bank debt. It is also important to consider that in the context of a complex design-build agreement, legitimate disagreements may arise as to the cause of cost or schedule over-runs and therefore whether the responsibility to pay for them falls to the Contractor, the Project Company or the Off-taker. Moody's captures differences between debt obligations and construction obligations by applying a haircut to the value of the support provided by the Contractor and using that reduced amount as the input into the modeling. Haircuts are based on a review of existing rated PFI / PPP transactions and an internal survey of Moody's project finance analysts.
Moody's credit rating is used as the model input for the contractor's credit quality. Moody's will typically generate an internal credit estimate for unrated contractors to serve as the input to the construction model. When a joint venture (J-V) rather than a single company is acting as the Contractor, Moody's will follow the structure of the J-V agreement when modeling contractor support and will take into account whether the obligations are several or joint and several and whether they are capped at a particular level.
Loss Given Default Std Building before / after 12% Contractor Default Effect
14.00% 12.00% 10.00% Probability 8.00% 6.00% 4.00% 2.00% 0.00% 0.00%
12%
10.00%
60.00%
14
Further, the more complex the project, the higher the likely costs associated with replacing a defaulted Contractor. Moody's will thus apply higher costs to project loss severity for complex projects than for simple projects. As is the case with the loss distributions themselves, Moody's determined the contractor default effects through a review of its existing project finance ratings and by surveying our project finance analysts.
In practice, the replacement cost is likely to vary depending on when in the project the Contractor defaults. For example, if a Contractor default occurs early in construction, a replacement contractor would have to assume a large construction obligation based on another contractor's contract and design - which suggests that the replacement premium may be higher than the level above. In contrast, late stage defaults may have lower replacement costs relative to the original total budget, as the absolute construction amounts that remain to be spent are relatively low. Given the questionable increase in precision from modeling a time-variable default effect, however, Moody's employs a fixed Contractor default effect as a reasonable simplifying assumption.
19. Financial Guaranty insurance policies from monoline insurers would generally also qualify as financial supports. 20. In rare circumstances, Moody's has evaluated financial obligations from multi-line insurance companies in support of certain structured finance transactions as being of equivalent timeliness to those provided by monoline financial guarantors. See "Analyzing the Role of Multi-Line Insurance Companies as Primary Obligor in Structured Transactions", Moody's Special Comment, January 2004. 21. See LIQUIDITY.
15
Generally, Moody's will explicitly model only top-level performance supports - i.e. instruments that support the project as a whole and that name the project company and/or lenders as beneficiaries. In many cases, a contractor will also require that its sub-contractors provide their own performance supports - for the benefit of the contractor - or the contractor will take out its own insurance against sub-contractor default. Secondary levels of performance support such as these can be valuable to the project and are considered as part of the qualitative assessment of each transaction.
22. In operations, distributions on sub-debt are permitted, subject to the Project meeting the same financial thresholds that would have permitted distributions on the equity that the sub-debt replaces. 23. More detailed information about the asset correlation structure in CDOROM is provided in its User Guide, available on www.moodys.com.
16
Qualitive Considerations
The simulation model provides a consistent measure of credit risk within and between projects as well as a transparent assessment of the value of various types of external credit supports. However, quantitative models are limited by the range and complexity of the inputs they are designed to accept. Moody's ratings on debt instruments issued to fund PFI / PPP construction necessarily consider a broader range of factors than can be completely modeled. As a result, the model results are the input into a framework that considers four qualitative rating factors: the Construction Contractor; Project Complexity; Contract Framework; and Related Party Effects The application of these rating factors enables us consider whether the simplifying assumptions that are inherent in the use of the model are appropriate for a given transaction or there is a need to adjust the model results upward or downward. These qualitative factors may not be applicable if creditors are fully insulated from a project's construction risk - as is common, for example, in Australia through the use of bank letters of credit covering 100% of the rated debt during the construction period.
24. This approach differs slightly from that generally used in Moody's rating methodologies for non-financial industries. Typical corporate methodologies map the scores of issuers on various factors - including quantitative measures - to ratings and then weight the factor results to obtain an overall rating.
17
Average
Multi-year track record of successful completion of similar projects No track record with similar projects.
Below Average
Project is very large relative to the size of the Contractor. Not Suitable for Modeling N/A
Equity Investment in the Project It has become common in some jurisdictions for contractors to make an equity investment in the project. Contractors with an economic stake beyond their fee are generally be regarded as being more committed to the project's success and are less likely than the average contractor to walk away from a severely under-performing project, bolstering the rating.
18
Average
All technologies and techniques are very well established within the field with very high degree of confidence in outcome Average Where construction is to take place on existing sites, there is unlikely to be any material impact on construction works. Technologies and process used in construction are considered normal with usual application risks outstanding
Below Average
Construction takes place on live operating sites, involving a complex process of decanting services from one building to another and demolition works that may affect continuing operations; or construction processes are considered particularly unusual and challenging Rarely, when the construction environment is considered extremely difficult - e.g., a requirement to construct in a very contaminated environment
19
Average
Below Average
Construction Budget A contractor operating with a very aggressively priced construction budget, with small contingencies and narrow margins is more likely to experience cost over-runs than is one with conservative cost estimates and generous contingencies. Moody's will look to the technical advisor / independent engineer as well as to its own experience in rating project financings to judge the reasonability of the budget and building schedule. Given that PFI / PPP projects are awarded pursuant to a competitive bid process and contractors are under pressure to submit the lowest possible construction bid, Moody's does not expect to see Above Average outcomes on this factor very often.
Average
Vulnerability to Local Economic Conditions As the construction task in most PFI / PPP projects is a multi-year exercise, the contractor is potentially exposed to changes in the local markets for labour, materials and energy. This issue is likely to be a problem only rarely, as local economic conditions are generally well considered when a project company prepares its bid for a concession. However, if cited as a separate characteristic, it will generally put downward pressure on the model rating. Certain markets may be particularly vulnerable because of high projected construction activity and shortages of labour and materials. This condition is associated most often with venues that are preparing for a particular event, such as the infrastructure build associated with hosting the Olympic Games or in a sector experiencing an economic peak such as the minerals boom in Western Australia. This factor typically results in a generally high level of construction activity in the local economy and an inability to offset or transfer the risks of rising input costs, in both cases putting downward pressure on the rating. Moodys Special Comment
20
Below Average
CONTRACTUAL FRAMEWORK
PFI / PPP transactions are designed to shift certain of the financing, construction and operating risks of public infrastructure projects on to the private sector. To the degree that a particular concession agreement transfers significantly more or less risk than is typical, the model rating will be adjusted accordingly. In a PFI / PPP project's operating period, an analysis of the risk sharing embedded in the concession's contractual framework will focus largely on the balance between the complexity of the operators' responsibilities and the severity of the performance management, abatement and termination regimes. It may have a positive or negative impact on the risk characteristics of the project as a whole. In contrast, the construction period's single performance objective is to deliver the project on time, on budget and fit for its designed purpose. Therefore the construction framework analysis is more concerned with the degree to which the concession agreement assigns risks to the project that are beyond the project company's ability or intention to manage or control. In addition to the characteristics cited below, the assessment of a project's contractual framework also considers several pass/fail issues. A 'fail' would typically result in the project being characterized as Not Suitable For Modeling and might make it impossible for Moody's to assign a rating at all. Two common examples of pass / fail issues would be the presence or absence of an independent engineer / certifier to monitor the construction budget and control payments and the presence or absence of a comprehensive insurance package from a credit worthy insurer which has been vetted by a credible, independent insurance consultant. Site Related Issues Sites for PFI / PPP projects are usually selected by the off-taker or government long before the project company becomes involved. However, as part of the bid process, the project company is generally given access to any geotechnical or environmental assessments conducted by the off-taker so they may price their bid appropriately. The exposure of a project company to known or unknown site-related issues varies widely.
Average
Below Average
21
Site Access, Acquisition and Planning PFI / PPP projects may be exposed to increased costs and delays as a result of a failure by the Off-taker to acquire the land and / or provide access to the site; a failure to obtain the relevant planning and other permits required to build the project in accordance with the agreed design, or issues surrounding utility connections and diversions.
Average
Land has been / will be acquired by off-taker and handed over to project company at financial close. Failure to do so will be a full compensation (time and costs) event for project company. All permits are received or are well in hand with none likely to hold up construction. Off-taker commits to support the application for such permits where appropriate. No utilities diversions that could have a significant impact on project completion.
Below Average
Most land has been / will be acquired by off-taker and handed over to project company. The risk of delay is shared between the off-taker and the project company. Procurement of permits or utility connections has some potential to cause project delays or higher costs
Not suitable for Modeling Land acquisition risk (cost and / or timing) lies with the project company.
A failure by the off-taker to acquire the site and / or provide access to the project company is generally outside the control of the project company - making it difficult to mitigate the risk of delays or increased costs. Obtaining planning and other permits - whilst part of the contractor's day to day business and taken into account in pricing and scheduling - is also outside the control of the project company / contractor. In contrast, the off-taker may have the ability to exercise its statutory and regulatory powers to facilitate planning and other permits. Similarly, the off-taker will often be in a better position to ensure that the site is connected to all appropriate utilities and undertake appropriate diversions. Extraordinary Event Provisions (Force Majeure and Change in Law) Similar to the evaluation of risks regarding the project site, the evaluation of the contractual provisions regarding extraordinary events focuses on the degree to which the project company is exposed to risks it either cannot control or decides not to mitigate.
22
Average
Government / off-taker share risk of a nondiscriminatory change in law. Project has either reserved up to the limit of its exposure, the amount of potential exposure not sufficient to cause financial distress to the project or the project has passed change in law risk down to a sub-contractor that has backed its obligations with adequate security.
Below Average
Project company responsible for the effects of a non-discriminatory change in law; no risks are passed down or reserves maintained and project agreement does not provide for any resetting of fees in the event of a significant externality such as a change in law.
23
Other Related Party Effects Other parties to a PFI / PPP may also go beyond their contractual obligations and support a PFI / PPP project if it is in their long term economic interest to do so. For example, the lead equity investor in a Project may think it economic to make a small additional investment to complete construction - and by extension, earn the rights to the project's operating cash flows - rather than lose the entire investment should the concession be terminated for non-completion. Because, however it is difficult to predict such support in advance, Moody's is unlikely to consider the credit benefit of non-contractual support from other related parties in advance of evidence that it is occurring.
24
Liquidity
Liquidity analysis in the context of a typical industrial company considers the likelihood that it can survive for a period of time without access to the capital markets to refinance maturing obligations. In contrast, liquidity analysis for a PFI / PPP project in construction considers whether it can continue paying debt service either until construction is complete and the project begins to receive its operating payments or the concession is terminated and the termination payment has been received. If the qualitatively-adjusted rating of the project during construction already reflects its inherent credit profile (project complexity, the quality of the contractor, value of financial supports, etc.) then the requirement for liquidity is simply that there be enough of it so that the possibility of a liquidity-induced default does not add to the expected loss. Consider the impact on creditors should a project default on its debt before the construction sunset date, solely because of a lack of liquidity. Generally, the loss to debt holders in this situation would be greater than if construction was able to continue until the sunset date - if for no other reason than the cost-to-complete deduction from a termination payment usually falls as the project advances. Therefore, if a lack of liquidity can cause a default prior to the sunset date (or the date at which the construction risk mitigation package is entirely exhausted) the rating on the project should be lower than if that is not possible. Theoretically, the required liquidity would be the amount needed to ensure that the probability of a liquidityinduced default was consistent with the default probability component of the rating of the project as a whole. While it would be mechanically possible to construct probability distributions that considered the likelihood of construction schedule over-runs of various durations - and therefore measure the need for various amounts of liquidity - such an exercise is not practical in light of the limited additional precision it would bring to the model result25. As a result, Moody's has looked to its traditional practices for rating project financings in establishing liquidity thresholds for various rating categories in PFI / PPP projects.
Table 19: Minimum liquidity levels for Rating Categories in PFI / PPP Projects
Target Rating Range Aa Standard Projects Committed liquidity sufficient to pay all debt service from the scheduled construction date through to the date by which the termination payment would be received or the debt redeemed from letter of credit or other proceeds. Sufficient liquidity to cover a 30% construction schedule over-run, subject to a three-six month minimum. Sufficient liquidity to cover a 15% construction schedule over-run, subject to a three month minimum. Complex Projects Committed liquidity sufficient to pay all debt service from the scheduled construction date through to the date by which the termination payment would be received or the debt redeemed from letter of credit or other proceeds. Sufficient liquidity to cover a 30% construction schedule over-run, subject to a three-six month minimum. Sufficient liquidity to cover a 15% construction schedule over-run subject to a three month minimum.
Baa
The most credit is assigned to liquidity support structured as a cash-funded debt service reserve account in a regulated deposit-taking institution with a Moody's rating at least as high as the target rating for the project's senior debt. Liquidity support via letters of credit or other financial supports - as defined above - are also valuable. As previously discussed however, Moody's considers performance supports to have only limited liquidity value. To the extent that any portion of the risk mitigation package's financial supports are either notionally or potentially dedicated to liquidity, those amounts will be subtracted from the amounts available for credit support during the modeling of the transaction. It should be noted that the role of liquidity in construction is different from its role in operations. Once a project has been completed and begun operations, the role of liquidity is to provide a buffer against the effects of payment abatements for non-performance by providing enough time for the operational difficulties that caused the abatement to be corrected. Operations period liquidity will be addressed in the operational period methodology to be published in the coming weeks.
25. Not only is data on schedule over-runs likely even harder to obtain than on overall cost over-runs, such data would not be predicatively useful. Construction contractors generally have the ability to convert time to money and are likely to do so if it makes economic sense - rendering purely schedule-based data unreliable. For example, it may be much less expensive for a contractor to spend on overtime and accelerate a project than to suffer the expense of liquidated damages for the same period.
25
26
COMPLEX BUILDINGS
Buildings requiring unique or unusual design considerations as a result of any of space constraints, complicated site characteristics or requirements to maintain services throughout the construction period. Generally, brown-field redevelopment or refurbishment projects will be categorized as complex. Other examples include general or specialty hospitals or high security prisons.
27
Adjudication Bond
Not usual in the Australian market. Provided by a highly-rated bank licensed to do business in Australia and drafted in the form of a letter of credit. The obligation to pay is conditional on a statutory declaration from the beneficiary to the effect that (i) other security has been exhausted (ii) the contractor is either insolvent OR the adjudicator has made a determination under the Construction Contract in favour of the beneficiary.
NORTH AMERICA
Performance Bond
Provided by highly-rated multi-line insurers. Insures performance by the contractor of the construction contract obligation. On a default by the Contractor, the insurer is required to (i) support the existing contractor in the completion of its obligation; (ii) perform the obligation itself - usually by engaging a substitute contractor; or (iii) pay out a cash amount in lieu of performance. A performance bond is generally only callable if the default is clearly and demonstrably the fault of the insured. Unless explicitly specified, performance bonds typically do not provide for the payment of liquidated damages or other amounts for delays.
Sub-Contractor Insurance
Typically purchased by the contractor to insure the performance of sub-contractors it has engaged, it is an alternative to requiring that sub-contractors provide their own bonding. The project does not benefit directly from the purchase of such insurance. However, by making it more likely that the contractor will be able to absorb the default of its subcontractors, sub-contractor insurance contributes to the likelihood of the project being completed on time.
UNITED KINGDOM
Adjudication Bond
Pays against a claim from the project company against the contractor, where such claim has been approved by an adjudicator in accordance with the adjudication procedure set out in the construction contract. As a consequence, all claims contested by the contractor need to go through an adjudication procedure. The adjudication procedure will have clear timelines for the adjudicator to reach a final decision and issue a certificate of its decision. The adjudication bond will respond to the claim supported by the certificate of decision irrespective of whether or not the contractor subsequently seeks a court remedy to overturn the adjudicator's decision. If the contractor becomes insolvent, any outstanding or post-insolvency claim on the contractor (including claims for liability under construction contract termination) are referred to a referee under the terms of the adjudication bond. The referee is required to determine the contractor's liability and issue a decision within a defined timeline. The adjudication bond then pays against the referee's decision irrespective of whether the contractor or the surety provider subsequently seeks a court remedy to overturn the referee's decision. The referee procedure is designed to cover the concern that an insolvency of the contractor may effectively frustrate the operation of the construction contract adjudication procedure.
28
f (l ) =
1 l ( l ) 1 B( , )
with mean =
The first loss on the project is absorbed by the building contractor up to a pre-agreed level K. Hence when no defaults are considered, the exposure to loss on the project by the investors is given by Max(0,(L-K)). In other words, if the project over-run L is less than the amount K absorbed by the building contractor, then the loss to the investors is zero. If L exceeds K, then the investors must absorb the excess loss (L-K). The expected loss on the project over-run is then E[Max(0,(L-K))], which has a closed form analytical solution when no defaults are considered. In this case, it can be shown that
=
where L ~ B( + 1, ) .
P L K K P(L K ) +
Once the assumption that the contractor may default is introduced, the variable K becomes a function of X, K(X), where X is the indicator of the contractor default,
K K (X ) = 0
X =0 X =1
Further, if it is assumed that the contractors obligations are covered by a third party which could also default we have Expected Loss = E[Max(0,(L-K(X,Y)))] where Y is the indicator of the third part default. In this case
K1 K K (X , Y ) = 1 K 2 0
for pre-determined K1 and K2.
K = 0, Y = 0 K = 0, Y = 1 K = 1, Y = 0 K = 1, Y = 1
29
This can be extended to the case where the contractor has multiple layers of support, where each counterparty can default, and dependant on which counterparties have not defaulted, the attachment point varies. Moody's compares all projects against a 4 year idealized loss rate to generate ratings rather than the actual term of the construction project. Given this idealized 4 year timescale together with Moody's rating of each entity, the probability of default over the lifetime of the project for each entity can be determined from Moody's table of 'Idealized' Cumulative Expected Loss Rates. From these default probabilities, P (X=1) = x and P (Y=1) = yi where i represents support level number, we can find the default thresholds x and yi such that (x) = x and (yi) = yi where represents the cumulative distribution function of the standard normal distribution. Moody's uses a standard normal or Gaussian dependency structure for pair-wise asset correlations based on a set of assumptions defined mainly on the sector and geography of the entities26. The correlated random variables are drawn using a standard multi-factor model (see CDOROMTM v2.3 User Guide27 for a technical description) -
X j = G * Z G + I * Z I + I ,R * Z I ,R + 1 G I I ,R * j
where
Currently Moody's corporate CDS asset correlation assumptions are G =3% I takes the following values
Sector's Geographical Impact Global ("G") Semi-Local ("SL") Local ("L") Asset Correlation 6% 3% 0%
In addition, the correlation between the project and the contractor has been defined as 18% for an investment grade contractor and 36% for a speculative grade contractor. The default thresholds x and yi can then be compared to the standardized asset values xi. If the standardized asset value is below the default threshold, the asset is considered to have defaulted. The beta distribution recovery rate mean and standard deviation for the project over-run are obtained from the mean loss and loss standard deviation for the type of project being modelled. The recoveries on the contractor default have been modelled using a fixed negative digital recovery rate to allow for the extra cost incurred by the project on contractor default. This has the effect of shifting the loss distribution for the project to the right. The support level recoveries have been modelled using a beta distribution with assumed recovery rates mean and standard deviation for an equivalent SU Bond.
26. For corporate correlations, see Moody's rating methodology, "Moody's Revisits its Assumptions Regarding Corporate Default (and Asset) Correlations for CDOs", 30 November 2004 27. CDOROMTM v2.3 User Guide, Moody's Investors Service, 12 May 2006
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Due to the use of multiple beta distributions within this model, a closed form analytical solution is no longer available, and so Monte Carlo simulations have been run to predict the expected loss on the project. In each Monte Carlo trial, defaults and recovery values upon default are simulated for the project over-run, the contractor and each level of support. Losses on the project are then computed and averaged over a large number of simulations to give the expected loss on the project.
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Author Andrew J. Kriegler Production Associate Tara Cheparev
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