The issue of counterparty credit risk is increasingly a topic of heavy discussion across all industries. Yet there are large differences in risk-management sophistication: while advanced methods for managing and mitigating risks are applied in both the power and financial-services industries, many other industries still lag behind.
Among those still at the initial-transparency stage is the transportation and infrastructure industry, which applies risk-management methods only at a rudimentary level. That’s a problem, because the need for systematic risk assessments and more sophisticated risk management in supplier selection is obvious.
Rail involves technically complex products, such as high-speed trains and complete signaling systems for subway systems. It also represents large volumes per project, commonly ranging from the delivery of around 20 trains to more than 600 and involving financials of €500 million and more. The long-term nature of contracts (regarding both delivery and possible maintenance agreements) complicates the setup further.
This combination of complex circumstances can lead to severe consequences should a project fail. For example, when the delivery of trains in a Scandinavian country was reportedly more than seven years late and technical problems severely affected their use, compensation totaling €300 million had to be paid to the customer. In another case, the incompatibility of a signaling system with the subway of a European capital city only came to light two years after the contract had been awarded. The result was a retendering of the contract and an estimated additional cost of more than €120 million.
Indeed, the number, spread, and size of recent failure cases in the rail sector is alarming; operational risk is very common, and projects are prone to disruptions. We analyzed more than 20 cases, some of them with a negative impact of more than €350 million. In addition, we examined credit ratings in the rail sector, finding big differences among companies. In particular, we noted that lower-rated rail original-equipment manufacturers (OEMs) pose a greater default risk partly because while large agencies take cash or equity on hand into account when determining credit ratings, they don’t consider the external debt often used by OEMs to finance projects. Paradoxically, the awarding of large projects that result in increased debt burdens may actually put OEMs in a more difficult financial position.