Evaluating toll road credits

November 1, 2006

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It has been recently reported that the government of India has given its approval for six-laning of 6,500 km of national highways, including 5,700 km forming part of the Golden Quadrilateral at a total cost of Rs 41,210 crore. In terms of financing, the expectation is that private sector will commit investments of Rs 35,690 crore. Also the government, in order to accelerate implementation of highway projects of Rs 2,20,000 crore, has set a target of awarding 175 contracts for Rs 76,540 crore, all on BOT basis by March 2008. Since a number of these projects are going to be predominantly debt financed with repayments supported by toll collections, it would be timely and useful to have an analytical framework for assessing the credit quality of various types of toll roads and financing structures.

The toll road sector is evolving rapidly and has become increasingly global, as entities with the expertise to build, operate, maintain, and finance these facilities have lent their services across international boundaries. The private sector brings a level of competition and efficiency that can benefit toll road project development and operations. At the same time, traditional publicly managed toll roads continue to operate in many parts of the globe. The management structure of publicly managed toll roads may be affected in some cases by private sector involvement and in others may not, but management strategies will likely evolve over time to take advantage of project development and operational efficiencies to meet the growing transportation needs of increasingly urbanised economies.

Historically, toll roads, as an asset class, have been subject to relatively low default rates. However, a number of projects have been subject to periods of distress, in large part due to the inability to forecast initial traffic and revenue performance with accuracy. In stable, developed economies, incorrect predictions and project externalities caused downgrades, debt restructurings, workouts, and some payment defaults, such as in the US and Europe. In developing economies, the added risk of economic cyclicality has similarly caused downgrades and defaults, such as in Mexico with the 1994 fiscal crisis. In countries without a history of toll roads, affordability and the willingness to pay have affected project viability, as in the case of Hungary. Ultimate recovery was strong in most developed economies, but not as strong in developing economies.

Types of toll roads
Toll road financing, construction, revenue generation, and operation can be undertaken through several organisational structures and frameworks. Revenues can be generated through traditional direct user charges, in which motorists using the facility pay a toll, or through third-party payments. Third-party payments are typically from a public sector sponsor to a private sector concessionaire, either in the form of shadow toll payments based on facility usage or availability payments based on the concessionaire’s ability to meet certain performance benchmarks. Ownership and operating models range from public sector sponsor responsibility for all aspects of financing, construction, and operation to public-private arrangements in which the public sector owner grants a concession to the private sector to handle a toll road’s development and operation according to well-defined requirements and operating benchmarks. Whether publicly owned and operated or developed as a public-private partnership, toll roads can be organised as stand-alone projects, either greenfield or existing facilities, or as a system of toll roads with long operating histories serving well established markets.

User-Pay toll, shadow toll, and availability payment mechanisms
Both the public and private toll road model utilise the user-pay revenue mechanism. Under this system, a vehicle makes a payment via cash or an electronic method for the use of a road facility. The amount of the payment can either be a fixed charge or distance based. The amount of the payment is also a function of the type of vehicle, with two-wheelers and automobiles usually paying a lower base fee, and commercial and other multi-axle vehicles paying a higher fee on a graduated scale. In the explicit user-pay model, revenues are directly linked to traffic and thus susceptible to economic downturns, elasticity of demand from toll increases, rising fuel prices, and competing facilities. However, these risks are generally mitigated over time given the growing long-term value associated with toll facilities.

Historically, toll rate increases have resulted in some magnitude of traffic diversion in the short term; however, given the lack of quality competing free roads, traffic levels have recovered (the pace of which is a function of local conditions) given growing demand and time savings.

Typically shadow toll and availability payments are in the form of a medium- to long-term concession, whereby a private contractor receives payments over time for the successful construction and operation of the facility from a public sponsor. The user is not responsible for a payment. In the case of shadow toll roads, the amount of payment is a function of a theoretical toll rate per vehicle with revenue minimums and maximums in many cases, limiting exposure to traffic forecasting risk to the operator on the low end and limiting the government’s exposure to increased subsidy on the high end. Revenues on road availability payment schemes are generally a function of satisfactory operations, maintenance, and capital reinvestment.

In the shadow toll model, the road user has no price incentive to use another road. Criteria used by governments for choosing this funding method have included more efficient project delivery and operations versus traditional means, lack of alternative free roads, political unwillingness to directly charge users, insufficient traffic for a user-paid toll to be feasible, and a lack of appetite in local financial markets to invest in user-paid roads.

While availability payments have no traffic risk, they have other types of exposure. Once construction is complete, satisfactory operations and maintenance remains the primary risk in availability payment structures. This risk is manageable since these costs tend to be smaller and more predictable, though financial margins can be partially eroded. Additionally, predictable and limited mandatory capital expenditures allow for more highly leveraged financial structures. As a result, high levels of unanticipated capital cost can rapidly eat into margins.

Public vs private
Generally, publicly operated toll facilities maintain a goal of operating solely in the public’s best interest by providing an essential service at the least cost. In contrast, private operators maintain a goal of maximising cash flows and returns to equity partners while providing an acceptable level of service.

Historically, public sector goals have been achieved with conservative debt structures and low toll rates. While debt structures were flat to slightly escalating in most cases, that is changing with the higher cost of system expansions and start-up projects. Additionally, public entities have a track record of limiting toll increases due to political considerations, despite their economic ability to raise rates.

In most cases, privately operated toll facilities have had greater success at regularly imposing toll rate hikes due to the generally growing economic rate making ability of most toll facilities, the profit motive, and less concern by management of the political implications. When concessions are initially granted, toll rates tend to be lower than revenue maximisation levels. Nevertheless, once under concessionaire control, toll rates will likely increase to maximum economic or legal revenue levels.

While the analytical considerations are largely the same, the differing motivations of public and private sector management result in key distinctions in their toll-rate structures, abilities and willingness to raise tolls, revenue and expense profiles, legal frameworks, and debt structures. Nonetheless, both publicly and privately operated toll facilities have achieved investment-grade ratings, in some cases very high ratings with appropriate legal structures, debt and liquidity levels, financial flexibility, and reasonable traffic and revenue projections.

In the public sector model, management’s independence, ability, and willingness to act to maintain fiscal balance in challenging economic times are key rating considerations. The conservatism built into budgets and long-term forecasts for ensuring fulfillment of future obligations, as well as the ability to deliver capital programs and expansion projects on time and budget is also considered. Since these factors are often not completely within the control of a public entity, maintenance of untapped financial flexibility by a public operator to withstand downside stress events is an important input into the rating.

The key rating considerations for privately managed toll facilities are concession certainty, the independence to set toll rates within a clearly defined toll-setting framework, the strength and expertise of the sponsor, the maintenance of adequate levels of equity in the credit structure, and financial flexibility to withstand reasonable downside stress events.

Systems vs stand-alone facilities
Toll facilities classified as systems include main long-distance, interregional or regional routes linking multiple key economic centres and portfolios of major intra-regional corridors. They may be managed via structures such as government enterprise funds, independent public authorities, corporations, and investment funds.

Typically systems comprise a network of toll roads that produce a diverse revenue mix derived from both commercial and passenger vehicle traffic. Furthermore, systems also tend to have existing facilities that provide a cross-subsidy to expansion projects, usually in the short term during construction and ramp-up phases. Toll facilities classified as stand-alones include nonrecourse bridges, tunnels, connectors, and circumferentials, all of whose only source of revenue is that facility.

Systems with mature segments are generally able to support all direct operating and capital obligations with lower toll rates. Stand-alone facilities, depending on their level of maturity and debt, tend to need to charge higher toll rates to support all their obligations. Under private operation both tend to maximise the toll rates to maximise revenues and equity returns.

The ability to do so is generally greater with systems than with stand-alones. As a result, systems have a greater ability to be positioned to support high leverage by government policy to pay for public investment unrelated to the toll facilities themselves. While the geographical and economic diversity of systems provide inherent strength, such leveraging effectively makes their credit risk profiles more akin to those of stand-alones.