construction risk in ppp projects

Special Comment

Request for Comment on:

Summary

• Moody's is seeking comment on a plan to augment its current approach to evaluating construction risk inprivately financed, public infrastructure projects ("PFI/PPP") by introducing a quantitative model designedto improve the consistency and transparency of its analysis. The approach will also standardize the presen-tation of the qualitative factors considered in assigning ratings on these project financings.

• This Special Comment outlines Moody's proposed methodology and invites interested parties to comment.Please send comments to [email protected] with the heading Construction Risk by September 30, 2006. Asubsequent Special Comment, to be issued shortly, will request comment on Moody's revised approach torating the operating period risks of PFI / PPP projects.

• The quantitative model, which is an application of the approach underlying Moody's CDOROM softwarefor synthetic collateralized debt obligations ("CDOs") will, for four standard project classes, explicitlyincorporate Moody's assumptions about the likelihood of construction over-runs, the value of parent guar-antees from construction contractors as well as the benefit of various types of external financial supportsincluding performance bonds and letters of credit.

• The proposed approach models PFI / PPP projects on an expected loss basis. As a result, the analysis ofproject liquidity - ensuring that projects have sufficient cash reserves so that default probability is broadlyconsistent with the expected loss-based rating - is conducted in parallel with the quantitative modeling.

• The model results are an input to a rating framework that incorporates aspects of construction programsthat are less suited to modeling but that are nonetheless critical to the analysis of PFI / PPP infrastructurefinancing. The methodology is not an exhaustive treatment of all factors reflected in Moody's ratings, but itshould enable the reader to understand the key considerations and financial factors used by Moody's in thefinal rating determination.

• If implemented, the proposed methodology would be applied to the construction phase of qualifying newPFI / PPP projects globally. It would also be applied to those existing projects that have a significant por-tion of their construction tasks ahead of them. Some existing PFI / PPP projects may see their debt ratingschanged as a result of implementation but a majority are expected to remain unaffected.

TorontoAndrew Kriegler 1.416.214.1635Catherine DeluzAllan McleanLondonAndrew Blease 44.20.7772.5454Neal ShahSydneyNicola O'Brien 61.2.9270.8100David HowellTim SeeNew YorkBart Oosterveld 1.212.553.1653Daniel GatesNicolas Weill

Contact Phone

August 2006

Construction Risk in Privately-Financed Public Infrastructure (PFI / PPP / P3) Projects

2 Moody’s Special Comment

• Consistent with existing practice, the proposed methodology separately considers risks in the constructionand operations phases of PFI / PPP projects. As a result, should projects be structured with a significantlyhigher 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 ofthe 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 atno cost on execution of a usage agreement. For further information on how to obtain the model, pleasecontact Grant Headrick in Moody’s Toronto office at [email protected].

Moody’s Special Comment 3

Table of ContentsWhat is PFI / PPP? .......................................................................................................................... 4

About this Rating Methodology ....................................................................................................... 4Methodology Overview ...........................................................................................................................5

Understanding Construction Risk in a PFI / PPP Concession ............................................................ 6The PFI / PPP Structure...........................................................................................................................6The Design-Build Agreement ..................................................................................................................7Lenders' Exposure to Construction Risk ..................................................................................................7Expressing Construction Risk as Credit Risk..........................................................................................10What is CDOROM™?............................................................................................................................10

Modeling Construction and the Risk Mitigation Package ............................................................... 11Modeling Raw Construction Risk...........................................................................................................11

Construction Loss Severity Distributions ...........................................................................................11Modeling Contractor Support ................................................................................................................13

The Value of Contractor Support .......................................................................................................13Effects of a Contractor Default ..........................................................................................................14

Modeling Financial and Performance Supports......................................................................................15Modeling the Value of Equity.................................................................................................................16Correlations within the Construction Package .......................................................................................16

Qualitative Considerations ............................................................................................................ 17Combining Qualitative Adjustments with the Model Results...................................................................17When Qualitative Factors Dominate ......................................................................................................17Assessing the Qualitative Factors..........................................................................................................19

The Construction Contractor ..............................................................................................................19Complexity of the Project / Project Management Task........................................................................19Contractual Framework .....................................................................................................................21Related Party Effects .........................................................................................................................23

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


What is PFI / PPP?

Used extensively to finance public infrastructure in the U.K., where they were launched in the mid-1990s, PFI / PPPstructures are designed to shift certain financing, construction, and operating risks of public infrastructure projects tothe private sector. Private sector consortia are engaged through a public bidding process, to design, build, and operatevarious types of public infrastructure projects under long-term concession agreements from a sponsoring governmentor one of its agencies.

In addition to the U.K., where the structures are part of the government's Private Financing Initiative (PFI), thetechnique is being increasingly used in Australia and Canada, where the transactions are referred to as Public-PrivatePartnerships (PPP's or P3's) and they have also been introduced across continental Europe. PFI / PPP financing is notcommon in the United States, where most public infrastructure remains government owned, but there is increasinginterest in examining a range of private financing options for public infrastructure, as evidenced by the proposed Portof Miami Tunnel PPP.

Most commonly known for the construction and operation of public hospitals, the PFI / PPP financing approachhas also been used to facilitate the construction and operation of government buildings, such as courthouses or otheradministrative centres, as well as to carry out a range of other public policy-mandated services such as the constructionand operation of schools or mass transit terminals. PFI projects are usually distinguished from traditional governmentprocurement arrangements by the fact that they feature fixed-price, fixed-term construction contracts and incorporatea requirement to operate the completed facilities pursuant to pre-agreed performance standards over a long term (25+years) concession agreement.

Performance failures, during either the construction or operational periods, can lead to abatement of the paymentstream and, ultimately, to termination of the concession agreement. The risk of abatement or termination of the con-cession is usually offset by the experience of the contractor or operator and various levels of performance or surety sup-port. In addition, contractual provisions usually exist that permit the project company to replace sub-standardcontractors well before project termination itself becomes a possibility. Typically, the capital structure of the projectcompany also incorporates a tranche of loss-absorbing equity to provide additional credit support.

About this Rating Methodology

This report explains how Moody's proposes to evaluate the credit quality of PFI / PPP projects during their construc-tion periods. A subsequent methodology to be released shortly will speak to Moody's approach to rating the operatingperiod risks of PFI / PPP projects.

This methodology is intended to apply only to those projects that feature availability-based revenue streams. Thatis, projects that will earn their revenues if they ensure availability of the facility while meeting performance standardscommon in their industries.

Public infrastructure financings with significant patronage risk (also known as volume or market risk) such as tra-ditional toll roads and airports, share many characteristics with PFI / PPP transactions but are not included within thescope of this methodology.

This methodology is also not intended to apply to infrastructure projects with highly complex operating require-ments or significant post-construction, pre-operation commissioning risks, such as waste treatment plants or defenseprojects. However, the construction modeling aspects of this methodology may be extended to other classes of projectfinance which feature relatively homogenous construction requirements.

Moody's may in the future also consider applying elements of this methodology to project financings with con-struction risk that are rated on Moody's U.S. Municipal Bond Rating Scale1. A mapping of Moody's U.S. MunicipalBond Rating Scale to Moody's Corporate Rating Scale is currently the subject of a separate request for comment2.Should the proposal outlined in that request for comment be implemented, it would allow the modeling results to beexpressed on either the corporate or municipal rating scales.

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 Equiv-alent Ratings to Municipal Obligations" Moody's Special Comment, June 2006


METHODOLOGY OVERVIEWIn this report we will describe each of the components of a construction project in terms of its default and recoverycharacteristics and its correlation with the other project elements. The expected loss - and therefore the credit risk - ofthe project is based on a Monte Carlo simulation of each of the project's components. To obtain a final rating, theresult from a large number of simulations is overlaid with a series of qualitative factors that reflect each project'sunique characteristics.This report is divided into three main sections as follows:

1. Construction Risk in a PFI / PPP FrameworkThis section provides background on the typical structure of a PFI / PPP project that includes a construction obliga-tion. It describes the generic contractual structure governing the parties and how the design and construction respon-sibilities are assigned by the government / agency sponsor to the project company and ultimately passed on to thegeneral and sub-contractors.

It then discusses how lenders are exposed to construction risk via cost or schedule over-runs and the way in whichthose risks are limited through the operation of the 'cost to complete' tests that are typical to PFI / PPP concessions.We then summarize the various financial alternatives available to mitigate the risks during construction.

As construction risk in a PFI / PPP project is usually considered as a physical risk with credit risk consequencesrather than as a credit risk per se, we explain how we translate construction risk into the expected loss framework ofcredit risk used by Moody's ratings.

2. Modeling Construction RiskThis section describes how each aspect of a PFI / PPP construction project is modeled. It begins by explaining howthe modeling of raw construction risk on an individual project is simplified by classifying each project into one of fourbasic types: Standard Buildings, Standard Civil Infrastructure, Complex Buildings and Complex Civil Infrastructure. It alsopresents Moody's assumed default and loss characteristics for each project type as well as the differences between theloss profiles of construction projects and corporate obligations.

We also explain Moody's views on the ability and willingness of a construction contractor to support the perfor-mance of a project as well as the negative effects on a project's economics should a contractor default and have to bereplaced. The modeling parameters for construction, the contractor and various financial and performance supportsare then presented along with a brief discussion of how components of the project are correlated.

3. The Application of Qualitative Rating FactorsThis section explains the qualitative factors that are overlaid on the model result to generate a final rating. Each of thefactors, The Construction Contractor, Project Complexity, The Contractual Framework and Related Party Effects speak to ele-ments of PFI / PPP projects that are either not suitable for modeling or which are modeled via the use of simplifyingassumptions.

The model result implicitly assumes that each project is "average" on each of the qualitative factors. To the degreethat an individual project is materially stronger or weaker than the model-assumed average, the factor rating is notchedup or down from the model result. Factor ratings are then combined to obtain a final rating. In this section we definethe factors considered and provide examples of the ways in which projects may demonstrate that they are average,above average or below average for each.

Finally, the methodology discusses how the analysis of liquidity applies to PFI / PPP construction ratings as well as theway in which a project that successfully transitions from construction to operations may expect to see its rating changeover the project life.


Understanding Construction Risk in a PFI / PPP Concession

THE PFI / PPP STRUCTUREThe typical PFI / PPP transaction is governed by a master concession agreement ("Concession Agreement" or "CA")between the sponsoring government or agency (the "Off-taker") and a single purpose project company (the "ProjectCompany" or "Concessionaire"). The Concession Agreement sets out the obligations of the Project Company todesign, build and operate the project over the life of the concession.

The CA defines the construction deliverables and timetable3. The construction obligation is usually defined on afixed-price, fixed term basis although, depending on the level of design requirements finalized when the concession isawarded, some construction elements may not be completely specified. In addition to a target date for project comple-tion and acceptance, the CA also specifies a "Sunset Date"4 - the date by which the construction and acceptance mustbe complete or the concession will be terminated. Should construction stretch into the period between the target andsunset dates - also known as the "construction tail" - the Concessionaire continues to be responsible for completingthe project within the original budget. In addition, the Concessionaire may also be responsible for paying penalties orliquidated damages to the Off-taker.

As operating funds from the Off-taker generally will not begin flowing until construction is complete and theproject is accepted, the Concessionaire's capital5 is also the only source of funds for debt service for the whole of theconstruction period including the construction tail. The original project financing is either accreting during construc-tion or it includes enough funding to provide for the payment of interest until the target construction date and at leastpart of the way to the sunset date.

Should the project not be completed by the sunset date, the Off-taker can - and in some cases is obligated to - ter-minate the CA. Generally, the Off-taker is required to make a termination payment to the concessionaire based oneither the NPV6 of the future income and expenses of the project - including the expenses of finishing the project - orthe original construction contract amount less the remaining cost to complete the project to its agreed upon specifica-tions. The cost to complete is usually defined as including not only labour and materials but also the Off-taker's gen-eral costs of remediation of any improperly completed work, contract re-tendering, etc.

The project company's lenders are thus exposed to a loss if there is a termination based on a failure to completethe project on time, on budget and on specification. Losses result from the project's exposure to the cost to completeand the costs of carrying the project from the target date to the sunset date - and ultimately to the date that the Off-taker pays the termination payment 7.

The Project Company attempts to ensure that lenders will be repaid by passing on the construction risks in theCA to a construction contractor and/or by requiring the contractor to provide additional security in support of itsobligations.

3. The concession agreement and its schedules also define all of the operational parameters of the project including the responsibilities of the concessionaire, perfor-mance standards, hand-back requirements, etc. Discussion of Moody's proposed approach to rating PFI / PPP projects during the operating period will be the sub-ject of a forthcoming request for comment.

4. Also known as the "long-stop date".5. As well as any external credit supports that have been put in place for such a purpose. 6. Either directly, via a formula payout, or indirectly through a market tender mechanism.7. Other termination scenarios in PFI / PPP transactions are possible. As an example, the government usually reserves the right to terminate the project for conve-

nience. These scenarios are not covered in this report as they usually provide for creditors - or even creditors and equity investors - to be paid out.


THE DESIGN-BUILD AGREEMENTThe Project Company enters into a fixed price, fixed term design-build agreement (the "DBA") with one or more con-struction contractors8. The DBA provisions generally mirror the obligations of the Project Company to the Contrac-tor but typically feature even more stringent performance thresholds.

For example, if the sunset date for construction completion and project acceptance in the CA is 36 months, thesunset date in the DBA may be 3 - 6 months shorter. Similarly, if under the terms of the CA,the Project Company isresponsible for the payment of liquidated damages to the Off-taker in a delay scenario, the DBA typically requires thatthe Contractor be responsible for those payments in addition to any senior debt-service payments that are not other-wise provided for.

The difference in performance thresholds is designed to give the Project Company the time to react to construc-tion performance failures and, ultimately, to replace the Contractor and finish the Project with a substitute before theOff-taker can terminate the overall Concession Agreement.

LENDERS' EXPOSURE TO CONSTRUCTION RISK PFI / PPP creditors are rarely willing to accept the raw construction risk that the project doesn't get built on time andon budget. So, the Project Company will - in addition to structuring the DBA on generally more restrictive termsthan the obligations in the CA - either require the Contractor provide a construction risk mitigation package orarrange one itself and pass some of the costs on to the Contractor. In some jurisdictions, regulations also specify min-imum levels of external support that must be provided in order to be eligible to bid on government contracts.

The design of a construction risk mitigation package always begins with consideration of the stand-alone risk ofconstruction in a given project. It then incorporates any of several possible financial and performance supports. Thesupports are designed to shield the Project Company and ultimately lenders from cost or schedule over-runs on theproject and are also intended to raise the credit quality of the project debt during construction.

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.

Typical PFI/PPP Transaction Structure

Project Company

ConstructionGeneral

Contractor

Shareholders

Equity

Lenders

Debt

Operating Sub Contracts

Off-takerDesign - Build

Agreement

Construction Sub Contracts

Concession

Agreement


1. Raw Construction RiskExpressed in credit risk terms, raw construction risk is the expected loss on the stand-alone project. It can be anal-

ogized as the potential exposure of the sponsoring government or agency to cost or schedule over-runs for an averageproject 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 toabsorb 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. Asis discussed below, Moody's has grouped the majority of projects seen in PFI / PPP transactions into four project typesfor ease of analysis. The four are Standard Buildings, Standard Civil Infrastructure, Complex Buildings and Complex CivilInfrastructure.

Recognizing that it is difficult to capture any particular project's complexity given only four categories, Moody'salso considers a range of qualitative factors that can influence the amount of raw construction risk. Examples of thesefactors include the experience of the contractor with the particular type of project being constructed, the degree ofreliance on new and/or unproven technologies and the degree to which local economic conditions around the projectsite will affect the cost and availability of labour and materials over the construction period.

2. Contractor SupportThe 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 otherwiseexpected to be covered from operating income as well as any liquidated damages or penalties assessed against theProject Company. While in many cases the obligation is open-ended, the Contractor can often cap its liability at somepercentage 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.

Typical PFI/PPP Design-Build Structure

Project Company Construction CompanyDBA

Bank

Letter of Credit

ConstructionCompany Ultimate

Parent

Full/PartialGuarantee of Performance

Insurance Co./Bank

Performance/Adjudication Bond


Moody's evaluation of the value of contractor support to a transaction incorporates an opinion of both the abilityof the contractor to pay as required and its willingness to do so - rather than walk away and face reputation or legalchallenges. Importantly, Moody's also considers the impact of the scenario where the Contractor, despite its bestintentions, is unable to complete its responsibilities and needs to be replaced. In those circumstances, the project maysuffer not only from the time lost while a new contractor is located but also from the likelihood that substitute contrac-tors may charge a premium price to assume a project mid-contract.

3. Performance / Insurance-based SupportsPerformance supports are designed to guard against the default by a Contractor or one of its sub-contractors on theirconstruction obligations. Common types of performance supports include performance bonds, adjudication bonds,sub-contractor insurance and completion insurance10. These performance supports are distinguished from financialsupports (e.g. bank guarantees) - referred to below in section 4.

Usually written by highly rated financial institutions, most performance supports generally have the character ofinsurance policies written by multi-line insurance companies. In other words, in order to receive compensation fromthe supporting institution following a default on performance, the beneficiary is required to submit a claim for adjudi-cation, prove that the default is covered under the policy and substantiate the amount claimed for. Performance sup-ports are rarely settled on a timely basis and often settle for less than the face amount of the claim. As a result,although performance supports can improve the credit quality of a transaction, Moody's considers them to be of onlylimited liquidity value.

4. Liquid / Financial Supports The most common examples of financial supports are bank letters of credit, bank guarantees and demand deposits atregulated financial institutions.

To be considered a financial rather than a performance support, the instrument must be able to be drawn upon ona timely basis and there must not be any conditions precedent to the bank honouring the drawdown either in theinstrument itself or in any of the other project documents. In addition, while drawing on a support usually gives thesupport provider a claim on the project for the amount advanced, categorization as a financial support requires that thesupport provider's claim be properly subordinated to rated project debt.

As a result of the unconditional and irrevocable nature of the support, Moody's focuses on the ability of the sup-port provider to make good on its obligation - as represented by its rating - as the key attribute of a financial support.

5. Equity The capital structure of the Project Company usually features a tranche of equity ranging from 10% - 20% of the totalcapitalization which is provided by the project sponsors. Equity provides funding for the project budget and, in theevent 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 rela-tively low levels of performance and financial support while those placed directly into the debt markets usually includea 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 costto complete, the loss severity on a project - after considering the benefits of the construction risk mitigation packageand 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.


EXPRESSING CONSTRUCTION RISK AS CREDIT RISK Moody's long term ratings are primarily opinions about expected loss: they reflect both the probability of default on aninstrument and the likely level of financial loss suffered in the event of default.

To assess expected loss on a construction project, raw construction risk - which is associated with project complex-ity and the likelihood of budget over-runs - must be translated into credit risk. This enables Moody's to express thelender's net exposure to the construction package in terms of a Moody's rating equivalent.

To accomplish this, we use the following general analogies: Moody's definition of a default on a corporate bondholds that a default occurs if a scheduled interest or principal payment is missed, the borrower seeks judicial or regula-tory relief from the obligation to pay creditors or if the holders of the instruments in question agree to a distressedexchange of their holdings12. Our definition of default in a stand-alone construction project is analogous: the projectgoes over budget or over schedule.

Similarly, the construction analogue for the loss severity of a defaulted financial instrument - the percentage of parnot recovered by investors - is the amount of the budget overage plus the monetary consequence of a schedule delay, ineach case measured as a percentage of the Project Amount13. As it is impossible to determine a single loss severity inadvance, the generic term "loss severity" refers to the probability distribution of various levels of loss rather than a sin-gle point assumption.

Once raw construction risk is translated into its credit risk equivalent, the construction risk package can beexpressed as a portfolio of financial assets supporting a financial liability. The asset portfolio is made up of the con-struction obligation, the contactor's support and any performance or financial supports, while the senior liability to berated 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 abond that, rather than paying par at maturity, "pays" the project the right to earn the operating period cash-flows. Ifthe construction obligation "defaults", the loss to the project is the amount that the termination payment from theOff-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 ofa portfolio of financial assets supporting a financial liability - a CDO - Moody's has adapted its widely usedCDOROM software, originally designed to assess the credit quality of synthetic CDOs to allow it to be used to assessthe credit quality of a construction package.

12. The analogous events for structured securities - which may contemplate that interest or principal due in a given period may be deferred to later periods - are more complex. The focus for such securities is on uncured payment defaults or downgrades to Ca or C in anticipation of expected future payment losses, collectively known as Material Impairments. See "Default and Recovery Rates of Corporate Bond Issuers, 1920-2005", Moody's Special Comment, January 2006, and "Default and Loss Rates of Structured Finance Securities: 1993-2005", Moody's Special Comment, April 2006 for details.

13. The Project Amount is defined by reference to the contractual structure of the concession and, particularly, the termination regime that would apply in the event of a construction default causing concession termination.

Table 1: Mapping Construction Risk to Financial Risk Financial Instrument Construction Project

Probability of an instrument going into default (PD) Probability of the project going over time / over budget

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.

CDOROM™CDOROM™ is a Monte Carlo-based simulation model used by Moody's analysts to rate synthetic CDOs. It calculates theexpected loss (i.e. the credit risk) for a portfolio of financial assets based on each asset's default probability and recovery ratedistribution as well as how each asset's performance is correlated with the others in the portfolio.

How does the model work?A Monte Carlo simulation calculates the credit outcome for the assets in the portfolio for a large number of possibilities. It is nota cash-flow model of the portfolio. Rather, each possible outcome (a path) sees a certain combination of asset defaults andrecoveries. The expected loss on the asset portfolio is the weighted average of the path outcomes. The default and recoveryrate distributions chosen by the user, along with the pair-wise correlations between assets, define how likely certain paths are tobe taken. Together with a user-specified liability structure, which defines the priority of payment between the debt tranches thatfinanced the project, the simulation outcomes provide an expected loss and therefore a rating for each tranche of debt.


Modeling Construction and the Risk Mitigation Package

To simulate the performance of a PFI / PPP construction transaction, we must determine the default probabilities andloss distributions for the project and translate the value of contractor and performance supports into their financialsupport equivalents. Table 2 sets out the major components of typical PFI / PPP construction risk packages, theircharacter and the requirements necessary to model them.

MODELING RAW CONSTRUCTION RISK Rank ordering all PFI / PPP projects in terms of construction complexity and then determining individual defaultprobabilities and loss distributions is not practical - nor are minor distinctions in complexity between similar types ofprojects likely to be material in the context of the credit rating result. As a result, Moody's has simplified the analysis by grouping similar types of projects together for the purposes of mod-eling. The four types are:

• Standard Buildings;• Standard Civil Infrastructure;• Complex Buildings; and• Complex Civil Infrastructure.The types are based on a classification system defined in a study of the UK public procurement system conducted

for the UK Treasury in 200214.In addition to grouping projects by type, Moody's has also simplified the analysis by assuming the default proba-

bility for the raw construction project is 1. In other words, Moody's assumes that no project will come in under bud-get. It could be argued that ignoring the possibility of projects coming in under budget is a harsh assumption sincemany do. However because the project doesn't generally get to "keep" any of the savings realized in such circum-stances, such an outcome is equivalent to a zero loss scenario from the perspective of the project's creditors15.

CONSTRUCTION LOSS SEVERITY DISTRIBUTIONSLoss severity distributions on construction projects are much more tightly bounded than the distribution of lossesgiven default for (non-financial) corporations. This is primarily because the ability of corporations to make decisions tochange strategy, to enter or exit businesses or to modify their capital structures is far broader than in the projectfinance sector generally or PFI / PPP specifically.

Table 2: Modeling Requirements for PFI / PPP Construction Risk PackagesComponent Character Requirements for Modeling

Raw construction risk Physical project complexity Determinination of default probabilities and probability distributions for cost over-runs by project.

Contractor support Commercial contract Determinination of ability and willingness of contractor to stand behind project.

Impact on the project of a contractor default.

Performance support Multi-line insurance contract Determinination of relative value and timeliness v. an equivalent face value amount of a financial support.

Financial Support Bank obligation Bank rating.

Cash holdbacks, other Cash deposits or obligations supported by LC's Timing and certainty of cash receipts.

Bank rating.

14. See Appendix A, Project Complexity Definitions. For Mott MacDonald's definitions, see Review of Large Public Procurement in the UK, Mott MacDonald (2002), available at www.hm-treasury.gov.uk/greenbook

15. Such savings generally are for the benefit of the contractor.


Moody's review of ultimate recoveries from a sample of approximately 400 US bankruptcies and distressedexchanges of non-financial corporations suggests that historical variation in firm-wide average recovery rates is consis-tent 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 dis-tribution of losses on enterprises' liabilities given default17 .

In contrast to the relative freedom of corporations in unregulated industries to operate, the structure of construc-tion contracts generally and the structure of design-build agreements in PFI / PPP transactions in particular, tend tolimit the amount of cost and schedule over-runs to far below the levels experienced by unsecured creditors of defaultedcorporations. This is because:

• The construction obligation is well defined in advance, has been explicitly priced by the Contractor andgenerally cannot be altered. The cost of changes to the project requirements after the design has beenagreed ("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 con-struction, the budget sufficiency and the feasibility of the schedule. The Off-taker generally has also done acapability 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 independentengineer18 to monitor the progress of project and authorize payments to the Contractor. The independentengineer's responsibility is to review completed work, to satisfy itself that the works meets specificationsand confirm that the project is on budget and on schedule. The independent engineer is generally not per-mitted to release funds to the Contractor unless the amounts remaining in the construction account are suf-ficient 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 constructiontechniques 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 con-tractors 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".

Loss Given DefaultNon-Financial Speculative Grade Corporations

0.00%

0.50%

1.00%

1.50%

2.00%

-20% 0% 20% 40% 60% 80% 100% 120%

Loss (%)

Prob

abilt

y


Presented in comparison with the loss-given-default distribution for non-financial corporations cited above, theresults for PFI / PPP construction projects are consistent with beta distributions with the following characteristics:a

MODELING CONTRACTOR SUPPORT The relationship between a contractor and a PFI / PPP project is more complex than that seen in a typical financialservices transaction. To begin with, the Contractor is very closely linked to the project - indeed the Contractor is oftenan equity participant in the project itself. Yet, PFI / PPP transactions are explicitly designed to enable a contractormay be replaced if it fails to meet the performance specifications set out in the DBA.

As well, by assuming the obligation to build the project on a fixed price, fixed term basis, the Contractor providespotential credit support to the transaction. For example, the contractor is obligated to absorb excess labour or materialcosts within contractual limits. However, this support differs significantly from a typical external credit support — likea third party guarantee or an insurance policy — because the failure of a Contractor does not just simply remove thesupport itself, it hurts the primary obligation by increasing the cost of completing the construction contract.

THE VALUE OF CONTRACTOR SUPPORT In most PFI / PPP transactions, the legal entity responsible for construction is an operating subsidiary of the Contrac-tor's ultimate parent company. The financial strength behind the Contractor's commitment can come from the oper-ating subsidiary or from a full or partial guarantee of the subsidiary's obligation by its ultimate parent.

However, obligations under a construction contract are not debt obligations. As a result, while traditional mea-sures of credit quality - such as a rating - capture both an organization's ability and willingness to pay its debts, thatsame level of willingness may not be applicable to a non-financial obligation. In other words, when faced with a sig-

Table 3: Project LGD Means and Standard Deviations by Type1

Project Type Mean Loss Loss Std Deviation

Non-Financial Corporate 48% 28%

Standard Building 8% 8%

Complex Building 15% 12%

Standard Civil 11% 12%

Complex Civil 18% 14%

1. Rounded to whole numbers.

Loss Given DefaultNon-Financial Corporations & Construction Projects

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00% 100.00%Loss (%)

Prob

abili

ty

Standard Corporate Standard Building Complex Building Standard Civil Complex Civil


nificant cost over-run, a contractor may be more likely choose to walk away from the contract - and face the subse-quent legal and reputation consequences - than to walk away from a comparable bond or bank debt. It is alsoimportant to consider that in the context of a complex design-build agreement, legitimate disagreements may arise asto the cause of cost or schedule over-runs and therefore whether the responsibility to pay for them falls to the Contrac-tor, the Project Company or the Off-taker.

Moody's captures differences between debt obligations and construction obligations by applying a haircut to thevalue of the support provided by the Contractor and using that reduced amount as the input into the modeling. Haircutsare 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 gener-ate 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 thestructure of the J-V agreement when modeling contractor support and will take into account whether the obligationsare several or joint and several and whether they are capped at a particular level.

EFFECTS OF A CONTRACTOR DEFAULTReplacing a defaulting Contractor takes time. Thus, in the context of a fixed price, fixed term DBA, any delay movinga project forward also has a monetary cost. In quantitative terms, the impact of a Contractor default can be describedas moving the loss distribution for the project to the right.

Adding to the problem is the potential difficulty of finding a qualified replacement contractor that is willing totake on the responsibilities of the defaulted Contractor. Not only would the replacement contractor need to familiarizeitself with the project, it would have to either step into existing sub-trade contracts or go to the expense of replacingthem. In a worst case, some already completed work might even need to be re-done.

For example, if the contractor on a $100 construction project defaults, the project - which had, as all projects do,an intrinsic risk of coming in over-budget - still retains its original risk of coming in over-budget, but it must also "pay"both for the additional cost of finding a replacement contractor and for whatever premium over the original contractprice is demanded by the replacement. For a standard building, this cost - measured in both out of pocket costs and interms of the cost associated with the delay - is assumed to total an additional $12.

Table 4: Mapping Construction Contractor Support to Model InputsNotional amount Amount of the construction contract obligation guaranteed by a

substantial contractor operating company or the contractor's ultimate parent

Value after haircut 66% of the first 50% of the guaranteed construction obligation PLUS 33% of the remaining guaranteed construction obligation

Loss Given DefaultStd Building before / after 12% Contractor Default Effect

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00%Loss (%)

Prob

abili

ty

Standard Building Std Bldg w/ Contractor Default

12%


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 thecase with the loss distributions themselves, Moody's determined the contractor default effects through a review of itsexisting 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. Forexample, if a Contractor default occurs early in construction, a replacement contractor would have to assume a largeconstruction obligation based on another contractor's contract and design - which suggests that the replacement pre-mium may be higher than the level above. In contrast, late stage defaults may have lower replacement costs relative tothe original total budget, as the absolute construction amounts that remain to be spent are relatively low. Given thequestionable increase in precision from modeling a time-variable default effect, however, Moody's employs a fixedContractor default effect as a reasonable simplifying assumption.

MODELING FINANCIAL AND PERFORMANCE SUPPORTSThe value of financial and performance supports to a construction project are a function of:

• the credit quality of the issuing institution;• the structure of the support; and • the conditions precedent, if any, to their use.To be considered a financial rather than a performance support, the instrument must generally be issued by a reg-

ulated, deposit-taking institution, be available to be drawn on a timely basis and there must not be any conditions pre-cedent to the drawdown, either in the instrument itself or in any of the other contracts governing the project.

As a result of their unconditional and irrevocable nature and - importantly - the consequences to the issuer of nothonouring the instrument on a timely basis, financial supports are modeled at face value using their Moody's rating asthe indicator of credit quality. Bank letters of credit, bank guarantees and demand deposits are typically the only obli-gations treated as financial supports19.

All other supports are treated as performance supports. This includes instruments drafted identically to a bankletter of credit but issued by a multi-line insurance company. This treatment reflects the nature of insurance contractsas compared to bank letters of credit. Specifically, disputing payment under an insurance contract has limited capitalmarkets consequences for an insurer while failing to pay a letter of credit on demand would generally be regarded as anevent of default for a bank. For similar reasons, a bank-issued adjudication bond issued in support of a PFI / PPPtransaction would also be treated as a performance support20 .

Based on internal estimates, the credit value of a performance support is modeled using its Moody's rating and50% of its face value. Moody's considers performance supports as providing only limited liquidity value to a PFI /PPP transaction21.

Table 5: Project Mean Losses w/ Contractor Defaults

Project Type Mean Loss

Effect ofContractor

Default

Mean Loss w/Contractor

Default

Standard Building 8% +12% 20%

Complex Building 15% +20% 35%

Standard Civil 11% +12% 23%

Complex Civil 18% +20% 38%

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.

Table 6: Modeling Inputs - Financial and Performance Supports Support Type Credit Quality Value

Financial Support Bank Deposit Rating Face Value

Performance Support Bank Deposit Rating or Insurance Financial Strength Rating

50% of Face Value

21. See LIQUIDITY.


Generally, Moody's will explicitly model only top-level performance supports - i.e. instruments that support theproject as a whole and that name the project company and/or lenders as beneficiaries. In many cases, a contractor willalso require that its sub-contractors provide their own performance supports - for the benefit of the contractor - or thecontractor will take out its own insurance against sub-contractor default. Secondary levels of performance supportsuch as these can be valuable to the project and are considered as part of the qualitative assessment of each transaction.

MODELING THE VALUE OF EQUITY Typically, PFI / PPP transactions are highly levered with no more than 10% - 20% of the Project Company's cap-

italization made up of equity provided by the project sponsors. Equity is either contributed up front at financial closeor, more commonly, is contributed near the end of construction in the form of funding to complete the project. If theequity isn't contributed in cash, it is typically supported by an unconditional, irrevocable letter of credit from a highlyrated financial institution.

The value of equity is indirectly captured in the model. The raw construction "asset" reflects the size of the grossconstruction obligation while the "liability" being rated is set at the lesser of the construction obligation or the seniordebt amount. As a result, the model reflects the extent to which the equity commitment is available for loss absorptionon the construction project rather than for the payment of other transaction costs.

Project sponsors often seek to provide a portion of their project contribution in the form of deeply subordinateddebt rather than as common equity of the Project Company. The ability to structure an equity-like contribution assubordinated debt will vary by jurisdiction. Generally, Moody's will consider some level of deeply subordinated debtequity-like as long is it is permanently subordinated and postponed during construction22 and it confers no rights ofaction on the subordinated lender - including acceleration or cross default.

CORRELATIONS WITHIN THE CONSTRUCTION PACKAGE Modeling construction risk and a construction risk mitigation package as the equivalent of a portfolio of financialassets requires not only that each of the "assets" be properly characterized but also that the relationship between theassets is captured. In modeling portfolios of financial instruments in CDOROM, Moody's assumptions about corre-lations are based primarily on two sets of data: Moody's corporate rating transitions study and Moody's KMV's calcu-lated asset correlations. These assumptions capture regional correlations in conjunction with a designation of eachindustry as local, semi-local, or global.

The financial elements of the construction mitigation package are assigned correlations as if they were financialobligations of the organizations that issued them. For example, contractor support, performance bonds and letters ofcredit are treated for correlation purposes as if they were bonds issued by the contractor, the multi-line insurance com-pany and the LC bank, respectively.

Similarly, the construction project is characterized - for the purposes of determining its correlation with the otherassets in the portfolio - as if it were the debt obligation of a speculative grade company in the construction industry. Inother words, the correlation between the project and its contractor is the same as would normally be assumed whenmodeling the debt obligations of two different contractors operating in the same market. This gives the project an18% correlation with investment grade contractors or a 36% correlation with a speculative grade contractor23.

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.

Table 7: Modeling Inputs - Contractor / Project Correlations Project S. Grade Contractor I. Grade Contractor

Construction Project 100% 36% 18%


Qualitive Considerations

The simulation model provides a consistent measure of credit risk within and between projects as well as a transparentassessment of the value of various types of external credit supports. However, quantitative models are limited by therange 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 rangeof factors than can be completely modeled. As a result, the model results are the input into a framework that considersfour 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 duringthe construction period.

COMBINING QUALITATIVE ADJUSTMENTS WITH THE MODEL RESULTSThe PFI / PPP construction approach assumes, for the purposes of modeling, that the project meets a certain expectednorm for each of the four factors above. To the degree that a particular PFI / PPP construction project is materiallyabove or below the expected level it will score a higher or lower rating than the model result would otherwise indicate.The qualitative factors are then combined to generate a final rating for the project 24.

The usual outcome for each of the attributes that make up a factor evaluation is for the project to receive one ofthree grades: Above Average, Average and Below Average. A fourth possible outcome, Not Suitable for Modeling is dis-cussed further below. The outcomes are then added together to form the final rating. Generally, the combinationresults are symmetric (an Above Average result on one characteristic will offset a Below Average on another), reflectingthe offsetting influences that the different factors can have on a transaction.

However, as projects can score above or below the norm in more than one attribute per factor and as the marginalcredit effect of additional positive or negative attributes diminishes, it is unlikely that qualitative factors will move thefinal rating more than two notches up or down from the model result.

WHEN QUALITATIVE FACTORS DOMINATEWhen consideration of the qualitative factors applicable to a particular transaction lead Moody's to conclude that themodel is a not suitable basis for rating the project, Moody's will apply its traditional project finance methodologies torate the transaction debt, but will use the model result to inform the rating committee discussion.Some examples of cases in which where a model-based approach would likely not be appropriate are projects in which:

1. the construction task is not comparable to or is more complex than the four standard project types;2. the technology underlying the project's operations has not been previously used in a similar application

and/or in similar environments; or3. the project is not situated in an economy with a track record of private sector financing for public

infrastructure.

ASSESSING THE QUALITATIVE FACTORSThis section explains some of the most common qualitative characteristics that may influence a project's rating andhow we factor these into our final rating. Given the complexity of PFI / PPP structures and the variations in the wayin which they are implemented from jurisdiction to jurisdiction however, the listing is not exhaustive.

To the extent that a project's final rating reflects qualitative adjustments of the type listed below, Moody's willdescribe the expected characteristic for a given factor, the way in which the project deviated from the expected leveland the way in which all of the qualitative factors collectively affected the final rating on the project.

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.


THE CONSTRUCTION CONTRACTORThe simulation model captures Moody's view of the contractor's credit quality and the likelihood that it will fulfill itsobligation to build the project at a fixed cost within a fixed time. In addition to credit quality, Moody's also considersthe circumstances in which a particular contractor is more or less likely than the average contractor to be called uponto fulfill its credit support obligation.

To make this assessment, we consider a contractor's track record of completing similar projects. We also take intoaccount whether the contractor is tied to the success of the project - beyond its fee - by virtue of an equity investmentin the project itself, the degree to which the contractor has shielded itself from sub-contractor performance failuresand contractor's size relative both to project and to its other commitments.

Thus, if a contractor has a particularly strong track record with a project type or if it has insulated itself - andtherefore the project - from the risk of subcontractor underperformance, the credit quality of the project may behigher than otherwise indicated by the model

• Relevant Experience / Track RecordAs part of the contractor assessment, Moody's determines whether the contractor is experienced with the typeof project at hand. Our standard assumes a track record of largely on-time, on-budget projects completedover several years. A contractor with an exceptionally strong record - in complex projects - can improve therating. Projects relying on contractors with limited or no experience with the project type are likely to see afactor rating lower than the model result. In evaluating the contractor's track record, Moody's will consider its project history and examine the criteriaused by the design-build consortium in selecting the contractor.

• 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 tothe project's success and are less likely than the average contractor to walk away from a severely under-per-forming project, bolstering the rating.

Table 9: Contractor Track RecordStandard Projects Complex Projects

Above Average N/A DBA consortium is composed of recognized industry leaders in the design / construction of projects in this class and jurisdiction

Average Multi-year track record of successful completion of similar projects

Multi-year track record of successful completion of similar projects

Below Average No track record with similar projects. Limited experience with similar projects in jurisdictions with similar legal and regulatory frameworks.

Project is very large relative to the size of the Contractor.

Project is very large relative to the size of the Contractor.

Not Suitable for Modeling N/A Project complexity / scope beyond the standard types


COMPLEXITY OF THE PROJECT / PROJECT MANAGEMENT TASK Even within a specific project type there will be differences in risk profile from project to project. As well, the degreeof conservatism of the construction schedule, the level of design risk and local factors - such as the predictability ofpricing for labour and materials over the life of the contract - can also differentiate one project from another.

• Project Simplicity & Feasibility of ScheduleMoody's assesses a project's simplicity and the feasibility of its construction schedule by comparing it to theaverage for its type. We do this by reviewing reports from the technical advisor and/or independent engineeras well as the off-taker's feasibility studies (where available) and the performance of similar projects rated pre-viously by Moody's

Table 10: Contractor's Equity Investment All Projects

Above Average Contractor's equity investment exceeds its expected margin on the project and is locked in beyond completion and acceptance.

Average Contractor either has no equity investment or the investment is less than its expected margin on the project.

Below Average N/A

Not Suitable for Modeling N/A

Table 11: Project SimplicityBuilding Project Civil Engineering Project

Above Average Construction is to take place on greenfield or brownfield sites with no material external elements likely to delay construction.

Construction takes place within an existing known space (e.g. for standard civil engineering - road extension / widening along existing alignment or for complex civil engineering construction - construction of a new bridge adjacent to an existing one using the same basic design.

All technologies and techniques are very well established within the field with very high degree of confidence in outcome

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

Construction is to take place on a greenfield and / or un-congested site with no particular environmental issues concerns or structures to cause concern. 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

New technologies or processes stretching the limits of what has been done previously, or construction is to take place in a challenging environment (e.g. construction of a structure in a highly congested urban environment, requiring extensive and difficult traffic management)

Not Suitable for Modeling Rarely, when the construction environment is considered extremely difficult - e.g., a requirement to construct in a very contaminated environment

The project is employing untried and untested material or processes, which provides material uncertainty that construction can be completed within a reasonable timeframe


• Construction Budget A contractor operating with a very aggressively priced construction budget, with small contingencies and narrow mar-gins 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 ratingproject financings to judge the reasonability of the budget and building schedule. Given that PFI / PPP projectsare awarded pursuant to a competitive bid process and contractors are under pressure to submit the lowest pos-sible construction bid, Moody's does not expect to see Above Average outcomes on this factor very often.

• Vulnerability to Local Economic Conditions As the construction task in most PFI / PPP projects is a multi-year exercise, the contractor is potentially exposedto 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 conces-sion. 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 shortagesof labour and materials. This condition is associated most often with venues that are preparing for a particu-lar event, such as the infrastructure build associated with hosting the Olympic Games or in a sector experienc-ing an economic peak such as the minerals boom in Western Australia. This factor typically results in agenerally high level of construction activity in the local economy and an inability to offset or transfer the risksof rising input costs, in both cases putting downward pressure on the rating.

Table 12: Reasonability of the Construction ScheduleBuilding Project Civil Engineering Project

Above Average Project involves the construction of multiple buildings but where interdependencies are minimal allowing rescheduling of tasks without affecting the critical path.

Project is split into phases or can be modularised for partial completion, enabling contractor to deliver specific phases of work earlier and counteract delays elsewhere.

Time contingencies provide good protection against uncertainties. Design work is well advanced

Time contingencies provide good protection against uncertainties. Design work is well advanced

Average Time contingencies provide good protection against uncertainties with total time floats equivalent to 5% - 10% of the total construction time allowed.

Time contingencies provide good protection against uncertainties with total time floats equivalent to 5% - 10% of the total construction time allowed.

Design work is well advanced by financial close, with outline designs complete

Design work is well advanced by financial close, with outline designs complete

Below Average Time contingencies are tight,and material slippage in the critical path would likely endanger final completion dates. Design work is not very well advanced.

Time contingencies are tight and material slippage in the critical path would likely endanger final completion dates. Design work is not very well advanced.

Not suitable for Modeling Either time contingencies are wholly inadequate, with material delays possible if construction takes take longer than expected or there is very limited design work by financial close.

Either time contingencies are wholly inadequate, with material delays possible if construction takes take longer than expected or there is very limited design work by financial close.

Table 13: Construction Budget All Projects

Above Average Budgeted unit costs are materially higher than expected based on current market forecasts for labour, materials, energy etc. and the contractor's ability to hedge purchases, OR Cost contingencies are generous, providing material support for possible cost overruns.

Average Budgeted unit costs are consistent with current market forecasts for labour, materials, etc., AND Cost contingencies are appropriate for the project.

Below Average Budgeted unit costs or cost contingencies are optimistic.

Not Suitable for Modeling No independent reports / insufficient reporting, no market data or independent consultants' reports to provide a view on costs


CONTRACTUAL FRAMEWORK PFI / PPP transactions are designed to shift certain of the financing, construction and operating risks of public infra-structure projects on to the private sector. To the degree that a particular concession agreement transfers significantlymore 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 contractualframework will focus largely on the balance between the complexity of the operators' responsibilities and the severityof the performance management, abatement and termination regimes. It may have a positive or negative impact onthe 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 forits designed purpose. Therefore the construction framework analysis is more concerned with the degree to which the conces-sion 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 considersseveral pass/fail issues. A 'fail' would typically result in the project being characterized as Not Suitable For Modeling andmight make it impossible for Moody's to assign a rating at all. Two common examples of pass / fail issues would be thepresence or absence of an independent engineer / certifier to monitor the construction budget and control paymentsand the presence or absence of a comprehensive insurance package from a credit worthy insurer which has been vettedby a credible, independent insurance consultant.

• Site Related IssuesSites for PFI / PPP projects are usually selected by the off-taker or government long before the project com-pany becomes involved. However, as part of the bid process, the project company is generally given access toany geotechnical or environmental assessments conducted by the off-taker so they may price their bid appro-priately. The exposure of a project company to known or unknown site-related issues varies widely.

Table 14: Vulnerability to Local Economic Conditions All Projects

Above Average N/A

Average Economic conditions foreseen and considered as part of the concession bid. Contractor has engaged in forward purchases of materials and energy for the project to the degree possible and transferred labour costs through sub-contracting or collective agreements that extend over the life of the construction project.

Below Average Economic pressures arose after bid was submitted or contractor did not take actions to

limit exposures to labour, materials and energy costs over the life of the construction project.

Not Suitable for Modeling Local / regional economy is suffering extreme distress.

Table 15: Site Related Issues All Projects

Above Average Government / off-taker is responsible for all pre-existing site conditions including all environmental, geotechnical and archaeological issues and holds the project company harmless for their effects.

Average Government / off-taker is responsible for all pre-existing site conditions not disclosed to the project company prior to financial close. Project company is responsible for the costs of dealing with any disclosed environmental or geotechnical issues.

Below Average Project company assumes full responsibility for the site at financial close but has had access to site assessments that are comparable in detail and scope to those reasonably expected to be completed in connection with an arms-length sale of the site itself.

Not Suitable for Modeling Project company assumes full responsibility for the site at financial close without access to a full site assessment (unlikely).


• 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 toacquire the land and / or provide access to the site; a failure to obtain the relevant planning and other permitsrequired to build the project in accordance with the agreed design, or issues surrounding utility connectionsand diversions.

A failure by the off-taker to acquire the site and / or provide access to the project company is generally outsidethe 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 intoaccount in pricing and scheduling - is also outside the control of the project company / contractor. In con-trast, the off-taker may have the ability to exercise its statutory and regulatory powers to facilitate planningand other permits. Similarly, the off-taker will often be in a better position to ensure that the site is connectedto 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 provisionsregarding extraordinary events focuses on the degree to which the project company is exposed to risks iteither cannot control or decides not to mitigate.

Table 16: Site Access, Acquisition and Planning Building Project Civil Engineering Project

Above Average Risks associated with obtaining all land, construction permits and procuring all utilities services (time and cost implications) remains with the off-taker.

Risks associated with obtaining all land and construction permits (time and cost implications) remains with the off-taker. No required utilities diversions that would likely have a negative effect on construction.

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.

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.

The acquisition of permits is not considered to be a problem. Off-taker commits to support the application for such permits where appropriate.

No utilities diversions that could have a significant impact on project completion.

Utilities diversions, while a risk of the project company, are not likely to hold up construction or result in significant cost overruns.

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.

Most land has been / will be acquired by off-taker and handed over to project company. Modest residual land acquisition risks are with the project company, but are expected to be manageable.

Procurement of permits or utility connections has some potential to cause project delays or higher costs

There may be material utilities diversion risks or acquisition of permits risks (possibly arising form local authorities).

Not suitable for Modeling Land acquisition risk (cost and / or timing) lies with the project company.

There are material land acquisition risks residing with the project company


RELATED PARTY EFFECTSMoody's generally expects that all parties involved in a PFI / PPP will be sufficiently experienced and capable of carry-ing out their responsibilities, be motivated to act in support of the Project's success and that they will be faithful totheir contractual responsibilities as written. We do not assume that any of the parties will go beyond their contractualobligations and support a PFI / PPP transaction when they are not required to do so, nor that they will actively seek toavoid their responsibilities.

To the extent that actions by a related party call these assumptions into question, a qualitative adjustment may bewarranted. However, it would be rare to see the effect - positive or negative - at the outset of a project. As a result, itwould be unusual for Moody's to find anything other than an Average result for a new transaction in the absence ofrecent actions by the same parties in the same jurisdiction.

• Government / Off-taker PFI / PPP transactions represent an alternative infrastructure procurement mechanism for governments.However, because PFI / PPP projects deliver public infrastructure, factors beyond just pure economics mayaffect government decisions about their dealings with PFI / PPP concessions. In particular, governments may in some circumstances be inclined to support a PFI / PPP project beyondcontractual requirements - or more mildly, not enforce their contractual rights to the letter. This may happenwhen a project is important to the jurisdiction or if it is feared that the failure of the project may impair thejurisdiction's future access to the PFI / PPP market for politically or socially important infrastructure. On the other hand, some aspects of PFI / PPP transactions can be deeply unpopular with some groups able tobring pressure to bear on governments. This may be, simply, a groups' opposition to contracting out of pub-lic services to the private sector in principle or, more often, because some aspects of a transaction have a nega-tive effect on a certain constituency in some way. Governments themselves have also been known to changetheir policy perspectives or have objectives overturned by voters. Existing concession agreements can beenforced to the letter, challenged in the courts or, at the theoretical extreme, cancelled by the exercise of agovernment's sovereign power. In evaluating the effect of a particular government / off-taker on a project, Moody's will consider its demon-strated willingness to support previous PFI / PPP projects beyond the contractual requirements or, con-versely, the degree to which they are challenging existing concessions in the courts.

Table 17: Extraordinary Event Provisions Force Majeure - All Projects Change in Law - All Projects

Above Average Government / off-taker is explicitly responsible for making payments sufficient to service debt during all force majeure events.

Government / off-taker accept all change in law risk.

Average Government / off-taker and project company responsible for making limited payments during force majeure but: (i) project company liquidity is sufficient to cover the entire period from declaration of force majeure through concession termination and receipt of termination payment without relying on any ongoing payments, or (ii) Force Majeure risk is passed down to a sub-contractor that has backed its obligations with adequate security.

Government / off-taker share risk of a non-discriminatory 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 Government / off-taker and project company responsible for making limited payments during force majeure and project company does not have sufficient liquidity to cover the entire period from declaration of force majeure through concession termination and receipt of termination payment without relying on any ongoing payments.

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.

Not Suitable for Modeling An extended force majeure likely to cause a cashflow default on the project.

Contemplated changes in law likely to cause a default on the project.


• Other Related Party Effects Other parties to a PFI / PPP may also go beyond their contractual obligations and support a PFI / PPPproject if it is in their long term economic interest to do so. For example, the lead equity investor in a Projectmay 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 con-cession be terminated for non-completion. Because, however it is difficult to predict such support inadvance, Moody's is unlikely to consider the credit benefit of non-contractual support from other related par-ties in advance of evidence that it is occurring.


Liquidity

Liquidity analysis in the context of a typical industrial company considers the likelihood that it can survive for a periodof 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 com-plete and the project begins to receive its operating payments or the concession is terminated and the termination pay-ment 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 issimply 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, solelybecause of a lack of liquidity. Generally, the loss to debt holders in this situation would be greater than if constructionwas able to continue until the sunset date - if for no other reason than the cost-to-complete deduction from a termina-tion payment usually falls as the project advances. Therefore, if a lack of liquidity can cause a default prior to the sun-set date (or the date at which the construction risk mitigation package is entirely exhausted) the rating on the projectshould be lower than if that is not possible.

Theoretically, the required liquidity would be the amount needed to ensure that the probability of a liquidity-induced default was consistent with the default probability component of the rating of the project as a whole. While itwould be mechanically possible to construct probability distributions that considered the likelihood of constructionschedule over-runs of various durations - and therefore measure the need for various amounts of liquidity - such anexercise 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 liquiditythresholds for various rating categories in PFI / PPP projects.

The most credit is assigned to liquidity support structured as a cash-funded debt service reserve account in a regu-lated 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 previouslydiscussed 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 poten-tially dedicated to liquidity, those amounts will be subtracted from the amounts available for credit support during themodeling of the transaction.

It should be noted that the role of liquidity in construction is different from its role in operations. Once a projecthas been completed and begun operations, the role of liquidity is to provide a buffer against the effects of paymentabatements for non-performance by providing enough time for the operational difficulties that caused the abatementto be corrected. Operations period liquidity will be addressed in the operational period methodology to be publishedin 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 contrac-tors 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.

Table 19: Minimum liquidity levels for Rating Categories in PFI / PPP Projects Target Rating Range Standard Projects Complex Projects

Aa 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.

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.

A Sufficient liquidity to cover a 30% construction schedule over-run, subject to a three-six month minimum.

Sufficient liquidity to cover a 30% construction schedule over-run, subject to a three-six month minimum.

Baa Sufficient liquidity to cover a 15% construction schedule over-run, subject to a three month minimum.

Sufficient liquidity to cover a 15% construction schedule over-run subject to a three month minimum.


Ratings after the Transition to Operations

In many PFI / PPP financings, construction period risks are sufficiently mitigated to cause the risk profile to bebroadly similar to that expected during the project's operational life. As a result, Moody's ratings on PFI / PPPproject financings have not generally experienced significant upgrades post-construction, regardless of jurisdiction oranalytical area.

However, through the use of different amounts and types of external support, it is relatively easy to structure thecredit risk of the construction period for a PFI / PPP transaction to the desired credit outcome. Depending on creditmarket demand and the cost of different credit enhancement options, projects may intentionally be structured to verydifferent risk levels during construction than in operations.

Moody's will comment at the time a rating is assigned on whether it believes there to be a significant differencebetween the risk profile in construction and operations and whether the rating is depressed during construction as aresult. Should the construction period risk profile be lower than that is expected to prevail in operations, the higherrisk operational period will depress the rating throughout the project's life.

Ratings changes as a result of a transition to project operations will generally not be considered until Moody's issatisfied that the project is successfully operating at or near expected levels and that it has done so long enough for anydesign or construction-related operational issues or problems to have been identified.


Appendix A: Project Complexity Definitions

STANDARD BUILDINGS Buildings not requiring unique or otherwise unusual design considerations. These include most office or residentialbuildings, out-patient or ambulatory care medical facilities, medium and lower security prisons as well as green-fieldairport terminal buildings.

COMPLEX BUILDINGS Buildings requiring unique or unusual design considerations as a result of any of space constraints, complicated sitecharacteristics or requirements to maintain services throughout the construction period. Generally, brown-field rede-velopment or refurbishment projects will be categorized as complex. Other examples include general or specialty hos-pitals or high security prisons.

STANDARD CIVIL INFRASTRUCTURE Projects involving the construction of facilities, in addition to buildings, not requiring unique or unusual consider-ations e.g. most new roads in areas without unusual geotechnical issues.

COMPLEX CIVIL INFRASTRUCTURE Projects involving the construction of facilities, in addition to buildings, that require special design considerations as aresult of space constraints, complex geotechnical issues or unusual output specifications. Also included are projectsthat incorporate innovative design, architectural or construction features or those that incorporate technically complexrequirements such as bridges or roadways in difficult terrain, any tunneling other than minimum amounts of 'cut andcover' tunnels and any projects requiring that existing services be maintained throughout the construction period.


Appendix B: Typical Performance Supports

AUSTRALIA

Performance Bond / Insurance Bond Provided by highly rated insurers licensed to do business in Australia. Insurer undertakes to pay the beneficiary onpresentation of the bank guarantee at its office. The obligation to pay is unconditional and on demand. The insureragrees to pay the beneficiary without reference to the insurer's customer, regardless of any notice from the insurer'scustomer not to pay, and without reference to whether there is any subsisting breach or default under the underlyingcontract in respect of which the guarantee is issued. These instruments are drafted identically to an Australian bankguarantee except that the provider is a multi-line insurer.

Adjudication BondNot usual in the Australian market. Provided by a highly-rated bank licensed to do business in Australia and draftedin the form of a letter of credit. The obligation to pay is conditional on a statutory declaration from the beneficiary tothe effect that (i) other security has been exhausted (ii) the contractor is either insolvent OR the adjudicator has made adetermination under the Construction Contract in favour of the beneficiary.

NORTH AMERICA

Performance BondProvided by highly-rated multi-line insurers. Insures performance by the contractor of the construction contract obli-gation. On a default by the Contractor, the insurer is required to (i) support the existing contractor in the completionof its obligation; (ii) perform the obligation itself - usually by engaging a substitute contractor; or (iii) pay out a cashamount in lieu of performance. A performance bond is generally only callable if the default is clearly and demonstra-bly the fault of the insured. Unless explicitly specified, performance bonds typically do not provide for the payment ofliquidated damages or other amounts for delays.

Sub-Contractor InsuranceTypically purchased by the contractor to insure the performance of sub-contractors it has engaged, it is an alternativeto requiring that sub-contractors provide their own bonding. The project does not benefit directly from the purchaseof such insurance. However, by making it more likely that the contractor will be able to absorb the default of its sub-contractors, sub-contractor insurance contributes to the likelihood of the project being completed on time.

UNITED KINGDOM

Adjudication BondPays against a claim from the project company against the contractor, where such claim has been approved by an adju-dicator in accordance with the adjudication procedure set out in the construction contract. As a consequence, allclaims contested by the contractor need to go through an adjudication procedure. The adjudication procedure willhave clear timelines for the adjudicator to reach a final decision and issue a certificate of its decision. The adjudicationbond will respond to the claim supported by the certificate of decision irrespective of whether or not the contractorsubsequently 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 claimsfor liability under construction contract termination) are referred to a referee under the terms of the adjudicationbond. 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 suretyprovider subsequently seeks a court remedy to overturn the referee's decision. The referee procedure is designed tocover the concern that an insolvency of the contractor may effectively frustrate the operation of the construction con-tract adjudication procedure.


Appendix C: Technical Information About The Model

The expected loss on the project over-run has been calculated using a Monte Carlo-based simulation model. This hasbeen implemented using the functionality of CDOROMTM, the model used by Moody's analysts to rate syntheticCDO transactions.As an introduction, assume that the over-runs on the project follow a beta distribution with probabilitydensity function

with mean and standard deviation

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)). Inother words, if the project over-run L is less than the amount K absorbed by the building contractor, then the loss tothe investors is zero. If L exceeds K, then the investors must absorb the excess loss (L-K). The expected loss on theproject 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

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,

Further, if it is assumed that the contractor’s 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

for pre-determined K1 and K2.

( )

========

=

1,100,11,00,0

,2

1

1

YKYKKYKKYKK

YXK

( ) ( ) ( )βαβα

llB

lf −= 1,

1

βααµ+

=( )( )2 1 βαβα

αβσ+++

=

( )( )[ ] ( )( )( ) ( )

( ) ( )KLKKL

llfKl

LKLKL

K

≥−≥+

=

−=

−=−

∫∫

∞

∞

P P

d

d ,0Max,0MaxE0

βαα

( ).,1~ βα +BL

( )

==

=100

XXK

XK

( )βα ,~ BL


This can be extended to the case where the contractor has multiple layers of support, where each counterparty candefault, 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 theconstruction project. Given this idealized 4 year timescale together with Moody's rating of each entity, the probabilityof default over the lifetime of the project for each entity can be determined from Moody's table of 'Idealized' Cumula-tive Expected Loss Rates.

From these default probabilities, P (X=1) = ρx and P (Y=1) = ρyi where i represents support level number, we can findthe default thresholds ∆x and ∆yi such that Φ (∆x) = ρx and Φ (∆yi) = ρyi where Φ represents the cumulative dis-tribution 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 ofassumptions defined mainly on the sector and geography of the entities26. The correlated random variables are drawnusing a standard multi-factor model (see CDOROMTM v2.3 User Guide27 for a technical description) -

where εj is the idiosyncratic factor specific to asset j.

Currently Moody's corporate CDS asset correlation assumptions are− ρG

− ρI takes the following values

In addition, the correlation between the project and the contractor has been defined as 18% for an investment gradecontractor 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 assetvalue 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 meanloss and loss standard deviation for the type of project being modelled. The recoveries on the contractor default havebeen modelled using a fixed negative digital recovery rate to allow for the extra cost incurred by the project on contrac-tor default. This has the effect of shifting the loss distribution for the project to the right. The support level recoverieshave been modelled using a beta distribution with assumed recovery rates mean and standard deviation for an equiva-lent 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

Sector's Geographical Impact Asset CorrelationGlobal ("G") 6%Semi-Local ("SL") 3%Local ("L") 0%

Sector's Correlation IntensitySector's Geographical Impact High ("H") Medium ("M") Low("L")Global ("G") 11% 6% 1%Semi-Local ("SL") 14% 9% 4%Local ("L") 17% 12% 7%

=3%

jRIIGRIRIIIGG

j ZZZX ερρρρρρ *1*** ,,, −−−+++=


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 con-tractor and each level of support. Losses on the project are then computed and averaged over a large number of simu-lations to give the expected loss on the project.

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