Basel II and Project Finance – the Architecture of a Cash-Flow Based Rating Model for the Controlling of Energy Projects

BASEL II AND PROJECT FINANCE – THE ARCHITECTURE OF A CASH-FLOW BASED RATING MODEL FOR THE CONTROLLING OF ENERGY PROJECTS

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Abstract

The following article describes the development of a Basel II conforming rating model for energy projects in the United States. Firstly, it gives an overview over the entire architecture of the rating module with its three parts: a) the macro layer; b) the industry specific layer and c) the cash-flow engine. The macrolayer provides a set of scenarios for the five macrofactors, which are the most important risk drivers for project risk – CPI consumer price index, SIR short-term interest rate, FXR foreign exchange rate to USD, GDP gross domestic product and oil price. The industry specific layer provides a set of scenarios for the industry related cash-flow drivers of energy projects –fuel prices, electricity demand etc. The object is not to achieve exact forecasts of variations in time, but rather to replicate the correlation and volatility properties observed in the past and distribute the different cash-flows trends realistically. Lastly, the cash-flow core, with quantitative and qualitative input factors is explained. Forecasts will be based on trends with and without a drift, experienced past volatilities or Monte-Carlo simulations. The rating model seeks to identify the probability of a borrower’s default (PD) as well as exposure at default (EAD) and residual value loss given default (LGD) The model has a huge impact on credit approval, analysis of capital adequacy, loss reserve levels and profitability, loan pricing and, the reporting of portfolio risk management to senior management.  

Joerg Orgeldinger, Dipl.-Kfm. (Germany), MBA (Great Britain)

Keywords: The tree layer approach - regression analysis - forecast scenarios -. Monte-Carlo simulations

JEL: G21, L72

1. INTRODUCTION

Banks which want to meet the advanced internal rating approach for specialised lending have to develop a sophisticated rating model for their project finance exposure (Basel 2000, p. 2-8 and Basel 2001, p. 1-15). “Internal ratings and default and loss estimates must play an essential role in the credit approval, risk management, internal capital allocations, and corporate governance functions of banks using the IRB approach.” (Basel 2004, p. 98). The project finance ratings are essential for the calculation of contributions to Value at Risk and Expected Shortfall of a credit loss distribution in the credit risk framework (Shinko, 2004, p. 527). The cash-flow based rating approach for project finance has been developed in contrast to the traditional accounting-based scorecards as described in Altman  (2000) or Back et al. (1996). The model has three main components: a sample data component for the macroeconomy, an industry specific and a cash-flow layer. The purpose of the macrolayer is to outline the projections of the most important macrospecific factors CPI Consumer Price Index, SIR short-term interest rates, real GDP Gross domestic product, oil price and FXR exchange rates. The macroeconomic environment influences default risk, with the difference that one macrofactor can have a significant influence on firms of different industries and rating grades (Salomone, p. 5). The industry-specific model provides a framework for computing a large quantity of future states of those variables (fuel prices, energy demand, generating prices and electricity demand) deemed to play the most important roles in energy projections. In the cash flow core the cash in- and outflows of the individual project are described in detail. For the calculation of the LLCR (=loan life coverage ratio) and DSCR (=debt service coverage ratio) the cash available for debt service consisting of excess cash-flow, sponsor support etc. is needed. The final probability of default PD is calculated and the assessment of qualitative factors is added to the credit appraisal.