Credit markets continue to be awash with liquidity despite the late stage in the credit cycle. Sentiment is good but investors are taking higher risks in the form of higher leverage, lower yields, longer tenors and migration into investment areas where they have less experience. All this is locking investors into positions that will pinch some fingers down the road.

“We see five key trends for the coming year,” said Aaron Konrad, director in Scope’s project finance team and author of the 2020 Project Finance Outlook, published today. “First, we believe the stable credit outlook is clouded by the growing risk of capital mis-allocation; second is the rise of merchant risk and what this means for investors. Third, we see the emergence of energy storage solutions as credit-positive for renewable energy projects, while emerging infrastructure technologies are gaining investor appeal (notwithstanding bankability concerns). Finally, energy policy will be the main driver for growth in European LNG.”

On the credit outlook, infrastructure and project finance has been one of the asset classes chosen by investors in search of yield and sentiment is euphoric. But some participants are starting to be concerned about the deterioration in credit fundamentals of some of the projects being initiated. “Incorrect pricing of risk today will be tomorrow’s losses when deflationary corrections crystallise after the next crisis,” Konrad said.

As a result, Scope’s credit outlook on European project finance is stable but reflects mixed fundamentals and trends in the context of tightening coverage ratios and rising leverage. In this context, sound economic fundamentals, supported by rigorous credit analysis, will be key to protecting investors from losses from defaults in the next economic downturn.

Demand for project finance assets will continue to grow, buoyed by ultra-low interest rates and ample liquidity. Nevertheless, the primary-market pipeline in most European project finance markets will remain sluggish, despite government efforts to tackle widely-acknowledged deficiencies.

The transition from fixed remuneration systems to open markets means that renewable energy investors will be exposed to higher risks, especially around energy prices. An industry that was once heavily subsidised and stable is becoming increasingly volatile, complex and uncertain. “In this environment, credit impairment events are more likely, especially those related to merchant risk. The higher probability of credit-impairment events driven by energy price fluctuations makes expected-loss analysis ever more important,” Konrad cautioned.

The 2020 Project Finance Outlook can be downloaded here.