DBRS Morningstar’s Takeaways from Credit Outlook Canada 2024: Creative Solutions in Infrastructure and Project Finance Emerging From Climate Change Pressure

As part of its takeaways series, DBRS Morningstar is publishing several write-ups about pertinent topics discussed at Credit Outlook Canada 2024. With a focus on “How Economic, Climate, and Tech Pressures Are Affecting Credit Quality,” this conference is a full day of global and Canadian market insights on what we should expect in the coming year. Arthi Sambasivan, Managing Director of Global Fundamental Ratings at DBRS Morningstar led her colleagues from project finance and infrastructure finance in a session titled “Infrastructure and Project Finance in an Era of Environmental Pressures and Rapid Tech Advances.” The panel discussed the impact of climate change on power generation, digital infrastructure, and airports and looked at how emerging technologies are being used to address these challenges.

POWER GRIDS OF THE FUTURE
“It’s always very complex to operate a power grid and overall these complexities are growing,” said Jaideep Nagpal, Vice President of Project Finance at DBRS Morningstar. The key challenges facing the power grid are extreme weather events, increasing intermittent renewable generation, aging infrastructure, policy uncertainty, and relatively unpredictable demand growth.

“A smart grid is operationally flexible, able to integrate the growing renewable sources, able to incorporate emerging technologies, able to react and respond to the ever-changing supply and demand, and overall resilient to ensure that we have a long-term, sustainable electricity supply,” Nagpal said. To facilitate that, improving grid technologies, including artificial intelligence (AI), can play a role in the future to help meet these challenges.

“Like in any other industry, climate change presents a growing risk and it’s going to have an impact on all three phases of the power system—generation, transmission, and distribution,” said Nagpal. More frequent and intense natural disasters, heat domes, and unpredictable weather patterns can lead to reduced generation output, resource uncertainty, loss of efficiency, increased equipment outages, and accelerated aging of the infrastructure.

THE ROLE OF RENEWABLES AND EMERGING TECHNOLOGIES
“Right now, on a global basis, coal, natural gas, and nuclear are the predominant sources of electricity,” Nagpal said. But this will change and more renewables will play a greater role as supply sources. Natural gas is the transient fuel that will get us to net zero and then, in the long term, renewable sources will take over. While that represents the long-term view, the probability of it happening is high because we expect that the strong policy support should continue. The last two decades were dominated by wind and solar while the coming decades will belong to these emerging technologies. As with all new technologies, there are uncertainties about their viability and cost, and policy support is needed to get these emerging technologies to get to mainstream . In the near term, battery storage is the dominant technology, with hydrogen fuel cells, carbon capture and small modular reactors expected to emerge in the medium to long term.

EFFECT OF CLIMATE CHANGE ON CREDIT RISK
“From a credit perspective, typical project finance-structured power projects are supported by long-term power purchase agreements (PPAs) that normally afford protections, such as force majeure clauses or generation curtailment protections in the event of economic (price-based) curtailment, safeguarding against extreme weather events, economic oversupply, etc., all of which makes the credit risk for these projects manageable, ” said Nagpal. In addition, projects are required to obtain adequate insurance, a crucial part of DBRS Morningstar’s credit assessment process, to protect against natural disasters. “At this time, we have not observed widescale impacts on our portfolio of project finance-structured power projects. We continue to closely monitor projects for climate change effects, such as higher generation volatility and other impacts that could lead to negative rating actions if deemed material,” said Nagpal.

DIGITAL INFRASTRUCTURE IN THE AI ERA
Digital infrastructure comprises the physical infrastructure that underlies the digital economy, primarily data centres, cell towers, and fibre networks. The three main impacts that AI has on digital infrastructure are its much higher use of power and environment control, more stringent demands on interconnectivity networking, and very different computing workload where a significant portion of processing is better done closer to the end user, rather than in a central location where it currently happens. All of these demands have credit implications.

“AI’s needs are different enough that we are beginning to see purpose-built designs that are more capital intensive and incorporate new technology. Credit-wise, at least for the initial build outs, these could be considered somewhat riskier—and because they are more expensive we want to see stronger sponsors,” said Victor Leung, Senior Vice President of Project Finance at DBRS Morningstar.

Data centres and networks have tended to aggregate in central locations and secondary locations were often considered less creditworthy or competitive. But that may be changing as the computing profile changes to emphasize more local processing. Existing centres built for older needs and in traditional areas may lose their competitiveness over time and Leung expects to see a gradual erosion of the creditworthiness of those facilities.

BROADENED DEMAND FOR PROJECT FINANCING
“I think people need to be aware of just how capital-intensive digital infrastructure is becoming, particularly in the face of AI requirements,” said Leung. The costs to build data centres to suit AI requirements can be almost three as high as that of previous, more general-purpose centres. “We’re talking costs of more than $1.0 billion, maybe $1.5 billion or more, just for the facility before you even consider the computer servers that go into it. Certainly, developers will need increased access to financing to help with the cost, and we have been seeing a significant increase in interest for financing during the construction and development stage as a result.”

AI semiconductors, with their strategic national security implications, are enormously expensive—semiconductor manufacturing facilities can cost more than $16 billion—and demand for them is increasing. The most advanced plants are all located in Asia, and although there is increasing political pressure to build them in North America, semiconductor manufacturers here are already capital constrained. These considerations are driving capital needs and innovative financing solutions are emerging. “We have recently seen a unique project finance deal with Brookfield partnering with Intel to help finance a chip foundry using project finance,” said Leung. “We’ve never seen that before.”

CLIMATE CHANGE TAILWINDS FOR DIGITAL INFRASTRUCTURE
Technology companies are concerned about the impact of climate change—severe weather, flooding—on their operations. In turn, these companies are also very aware of their impact on climate and many are at the forefront of using renewable PPAs to directly buy power from renewable generators to offset their enormous power usage. And as their power needs increase, DBRS Morningstar believes these renewable PPAs will increase correspondingly. The power required to support digital infrastructure also puts tremendous pressure on local power grids, which makes digital infrastructure providers look for alternative locations. One reason for moving digital infrastructure to secondary locations is for direct or indirect connection to renewable projects. There are companies currently dedicated to providing renewable power co-located with technology facilities, almost all in secondary locations and Leung expects to see that increase over time.

AIRPORTS ON THE PATH TO FULL RECOVERY AND NET ZERO
“The recovery has been strong, steady, and seemingly sustainable. The pace of recovery varies by different regions, with Asia lagging behind mainly due to China’s lockdown in 2022. The recovery profile has been pretty similar between Canada and the global market, which is not surprising given the interconnectivity of the aviation industry.” said Li. There were some temporary deviations due to country-specific restrictions but once those restrictions were lifted, Canadian air traffic volume caught up quickly to become on par with the global recovery level. “In short,” said Li, “we found the industry has demonstrated very strong resilience.”

“However, challenges remain in the path to full recovery,” Li continued. “One of the challenges continues to be extreme weather events and potential systematic failure, although I think the sector is better prepared, with more staff hired back and capital investment ramping up; however, it seems the air traffic control systems remain a weaker point.” Reportedly, there are still hundreds of air traffic controllers in training who will enter into service through next year. The other challenge is geopolitical instability. For example, even after China reopened in December 2022, the traffic volume from that market is still lagging because of the bilateral air restrictions between Canada and China, which have capped the capacity at around 14% of the peak level; however, the demand is still there, just waiting to be released.

While Li sees airports recovering operationally, he thinks some financial aspects will never be the same again. “The debt per emplaned passenger ratio—one of the key financial ratios we track—has really gone up compared with pre-pandemic levels,” he said. This is mainly because many airports had to borrow heavily during the pandemic, not to finance expansionary capital projects for future demand but to reinforce their liquidity. That may create some permanent impairment to the ratio, potentially squeezing airports’ capacity to borrow in the future.

The EBITDA per enplaned passenger ratio has already exceeded pre-pandemic level, thanks to rounds of aeronautical fee increases implemented during the pandemic. Li thinks this ratio may temper down eventually, however this may not happen anytime soon as right now each dollar of EBITDA is bearing more debt compared with 2019, creating a potential incentive for Canadian airports to keep their fees high or even consider further hiking up their fees if they want to have the same level of financial flexibility as they did three years ago.

When it comes to climate changes, alternative propulsion technologies such as battery- or hydrogen-powered aircraft are among the options being pursued by the airline industry. Even if these technologies are successfully commercialized, the majority of capital expenditure will be off-airport rather than on-airport, and mainly related to production or transportation. The actual spending by the airport sector will be significant but not beyond a level the sector can digest. The World Economic Forum estimates that by 2050, the airport sector will be required to spend up to USD 114 billion to accommodate these technologies. “It’s still a big number,” said Li, “but if you divide it by the number of major airports globally, it’s equivalent to around 20% of the capital cost to build London Heathrow’s third runway project and the investment will span many years.”

Written by Deirdre Maclean

Notes:
For more information on infrastructure and project finance, visit www.dbrsmorningstar.com or contact us at [email protected].

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