LIBOR transition - how transition away from the world's most important number will affect energy and project finance markets

Summary

• A vast amount of debt and hedging in energy and infrastructure finance markets will have an interest rate linked to LIBOR.
• As LIBOR and potentially EURIBOR are phased out, transition will be required to the new risk-free reference rates that replace them.
• Although LIBOR will not be supported beyond end-2021, Sterling markets are already migrating to new SONIA-linked products and this process will accelerate in the next 12-18 months.
• As compared to most corporate financings, managing the transition in energy and infrastructure transactions will involve additional risks and documentary complexity.
• To minimise disruption, borrowers should begin to develop their transition plans and prepare to implement transition once new risk-free reference rates are available for use.

Background to LIBOR transition and its impact on energy and project finance markets

It is estimated that globally there is as much as US$350 to US$500 trillion of financial products linked to LIBOR, a sizeable proportion of which has been originated in, or linked to, the energy and infrastructure lending markets. The next 12-18 months promises to be a period in which the energy and infrastructure finance markets begin the process of transitioning new and existing deals away from the use of (or reliance on) traditional interbank offered rates (such as LIBOR) towards alternative, nearly risk-free reference rates (RFRs) in setting floating rate interest for loan, bond and derivative products.

2019 and early 2020 is expected to witness a major acceleration in the transition from Sterling LIBOR to new RFRs with the increased use of the Sterling Overnight Index Average (SONIA) in cash and derivative products, as well as the possible development of new forward-looking RFRs, such as a new forward-looking term rate based on SONIA (Term SONIA Reference Rate or TSRR) currently under consideration by the Bank of England's Working Group.

In Euro markets, there are initiatives to reform EURIBOR to ensure that it complies with the Benchmarks Regulation before the expiry of the transition period.¹ In parallel, debate continues over whether a new, forward-looking term rate based on the Euro short-term rate (€STER) (which will be published by the European Central Bank from October 2019 and has been developed to replace the Euro OverNight Index Average) should be developed as a replacement to or fall-back for EURIBOR for Euro-denominated cash products.²

In the US dollar markets, some market participants have taken steps to transition to the Secured Overnight Financing Rate (SOFR) (the RFR identified by the Alternative Reference Rate Committee (ARRC) as the replacement for US dollar LIBOR) with leading supranational issuers, such as the European Investment Bank, having completed SOFR-linked bond issues in recent months.

How energy and infrastructure transactions are affected?

Managing the transition is a market-wide issue. Managing the transition in energy and infrastructure transactions will, however, be more complicated. This is primarily due to the long-dated nature of the financing arrangements (which accentuates the risk of any interest rate mismatch), as well potentially the greater number of counterparty consents that may be required for documentary amendments.

What are the consequences of failing to effect the transition?

A failure to manage the reference rate transition could have a number of different and adverse consequences depending on the relevant instruments and contractual provisions:

• lenders may seek to pass on their costs of funds to borrowers as an alternative to an agreed replacement rate, which may increase interest costs;
• floating rate interest may fix to the last available floating rate that was published;
• hedging agreements may be frustrated or otherwise cease to be effective;
• termination compensation payment obligations under PPPs/concession agreements may no longer align with the debt terms, unless the Authority's consent is obtained; and/or
• financial models and forecasts may no longer be accurate.

Some corporate financings will not face these problems in quite the same scale and degree as the energy and infrastructure finance markets, either because benchmark replacement mechanisms have been included in recent transactions to facilitate the transition or because the natural refinancing cycle of shorter term debt provides an opportunity to switch borrowers away from LIBOR to new RFRs.

However, in the energy and infrastructure finance markets – markets which commonly originate debt with longer term maturities – a significant number of legacy deals will be affected. Market participants will need to understand what changes are required, how they need to be implemented and what consents may be required. Furthermore, while most headlines have focussed on LIBOR ceasing to be available beyond 2021³, market participants need to be aware that transition will happen in earnest before then, not least driven by regulators' desire to mitigate the "medium term financial stability risk"⁴ by ensuring that regulated firms have robust transition plans in place well before the end-2021 deadline after which LIBOR will no longer be supported and may well cease to be published altogether.

Five key areas where LIBOR transition will affect energy and project finance transactions

We have identified five key areas in which many energy and infrastructure finance transactions will be affected. In each case, consent analysis will need to be carried out and amendments will need to be negotiated between counterparties.

1. Finance and hedging documentation – amending the benchmark: To avoid any economic prejudice to the borrower or lenders as part of the transition, frameworks are expected to be published and endorsed by central bank working groups for each of the LIBOR currencies. Their purpose is to reduce or eliminate any transfer of economic value from one party to another as a result of transactions being priced using RFRs instead of LIBOR. Not only will existing transactions have to be amended to determine floating rate interest payments using the new RFRs instead of LIBOR, but they may also factor in an "adjustment spread" or "adjustment payment" (which may be positive or negative) to maintain the same overall rate of return for lenders and investors as for a LIBOR based rate of interest.
   
   More recent transactions are likely to incorporate the latest fall-backs recommended by various trade associations and financial markets groups – such as the ISDA's Benchmarks Supplement, the LMA's 'Replacement of Screen Rate' rider, AFME's 'Benchmark Rate Modifications' rider and the ARRC's recommendations for robust fall-backs in floating rate notes and syndicated loans. However, while these fall-back terms may facilitate the process by minimising or, in some circumstances, eliminating the need for creditor consent to replace LIBOR with a new RFR, their application will still require careful management to ensure alignment with new market standards and the consistent application of the adjustment spread or adjustment payment, and to reduce the possibility of litigation risk from any stakeholder adversely affected by it.
2. Preserving the status quo on termination compensation: It is not just lenders' consent that will be required to approve the transition from LIBOR to RFRs. For PPP/Concession Agreements, it may be necessary to obtain the authority's consent in order to ensure the termination compensation obligations continue to align with senior and, if applicable, junior debt linked to a new RFR.
   
   Most projects procured on a PPP basis will link the authority's termination compensation payments to the finance documents which are in force at financial close. Any subsequent amendments – in particular, relating to interest calculations, break costs or the way in which hedging termination costs are calculated – will need to be approved by the authority if they are to be effective against the authority upon termination of the project.
3. Managing potential mismatches between hedging transactions and underlying debt: Market participants will want to ensure that transition across loan, bond and derivative products does not (unintentionally) lead to mismatched hedging of the underlying debt.
   
   LIBOR's well-established use across loan, bond and derivative in energy and infrastructure finance markets enables market participants to create perfectly or, at least, very well hedged structures where interest rate mismatches can be kept to a minimum. Implementing LIBOR transition will challenge this orthodoxy as different markets approach the challenge of transition in different ways. Borrowers may want to co-ordinate their hedging counterparties and lenders to achieve the same outcome across debt and hedging tranches of their capital structures.
   
   The derivatives market, in particular, has been at the forefront of developing tools to facilitate the transition through ISDA's publication of the Benchmarks Supplement⁵  and the Benchmarks Supplement Protocol⁶ and its consultation on potential fall-backs for use in derivative transactions that reference IBORs in certain currency markets.⁷   The consultation established a market consensus on the methods to be used to calculate the relevant RFR where it is a fall-back in a derivative contract.⁸   ISDA is now co-ordinating a working group to prepare amendments to the provisions typically used for interest rate products, being the 2006 ISDA Definitions, to implement fall-backs on the basis of these chosen methods. In order to enable market participants to incorporate these fall-backs into existing transactions, it is also preparing the ISDA IBOR Fallbacks Protocol, which is expected to be ready for publication in the next few months.
   
   However, sponsors and borrowers will need to understand how using these frameworks can create differences between floating rate interest payments under loans or bonds and the floating legs on interest rate swaps, and how strategically to manage the timing of transition with different creditor groups to avoid mismatches between hedging and debt terms. Once the ISDA IBOR Fallbacks Protocol is available, hedging counterparties are likely to encourage borrowers to adhere to the Protocol in the coming months; however, adherence may not be suitable in all scenarios, in particular where the transition economics on the underlying debt remains uncertain.
   
   Any amendment to hedging transactions will also need to be considered in the context of EMIR⁹  and hedging accounting treatment. LIBOR transition amendments could in some circumstances be regarded as being sufficiently material to question whether trades continue to be 'grand-fathered' – and therefore be exempt from margin posting requirements – under EMIR. On the accounting side, the International Accounting Standards Board has recently begun a consultation on changes to IAS 39 and IFRS 9 to provide relief from specific hedge accounting requirements that could have resulted in the discontinuation of hedge accounting solely due to the uncertainty arising from interest rate benchmark reform.¹⁰
4. Updating forecasts and financial models: Financial models and forecasts will need to be updated and economic forecasts will need to be amended (and such amendments could be combined with any consent requests relating to LIBOR replacement).
   
   For existing transactions, borrowers will need to amend economic assumptions and update financial models to take into account floating rate interest calculated using new RFRs plus any adjustment spread or adjustment payment recommended by the relevant working group for the relevant currency. While the economic bargain between a borrower and lender is not expected to change materially as a result of the transition and the introduction of an adjustment spread or adjustment payment, the economic assumptions relating to the projected LIBOR (or EURIBOR) level for the borrower will need to be updated and factored into Projected DSCR and LLCR forecasts. While more recent transactions may allow the facility or intercreditor agent to approve a replacement or successor rate for use in the economic assumptions, it remains to be seen whether agents will be prepared to use that discretion. Much will depend on the nature of the final recommendations from the working groups and how much subjectivity must be used in determining the transition economics. But given the importance of this figure to the project or borrower's projected forecasts, it is conceivable that these changes will need to be formally approved by lenders themselves.
5. Identifying and remediating other affected terms used in project and finance documents: Use of LIBOR terms in energy and project finance transactions is not only restricted to interest determination provisions.
   
   Market participants will need to review their finance and project documents to determine what other amendments may be needed and whether the use of RFRs is appropriate in all circumstances. Any transition plan will need to identify the exact scope of the amendments that need to be made, which transaction parties need to approve them and what level of consent are needed to obtain those approvals.
   Other terms in project and finance document affected by LIBOR discontinuation may include the following:
   
   Make-whole amount calculations, especially for fixed rate non-Sterling transactions where make-whole amounts are more commonly calculated on a swap rate;
   
   — Financial calculations that relate to floating rate debt;
   
   — Default and contractual rates of interest;
   
   — Other fees, e.g. calculated by reference to a LIBOR-based loan rate; and
   
   — Rates specified by licence or regulatory provisions.

Ashurst Advance – an end-to-end LIBOR transition solution

The transition to RFRs from LIBOR will require amendments to legacy contracts on a large scale. We understand that such large-scale documentation projects place unique demands on legal resources and strain budgets. With that in mind, we have developed Ashurst Advance: a single, global, integrated delivery platform, which provides an innovative blend of expertise, flexible resourcing, leading technology solutions and project management capability to plan, manage and execute such projects. This platform will be used to help our clients manage the transition to RFRs from LIBOR and we can design a process to fit your specific requirements.

We also understand that the challenge of LIBOR transition for the energy and infrastructure finance markets is more complex than other markets: LIBOR references are more deeply embedded in transactions and the array of amendments required to implement a complete transition to new RFRs will be much more extensive.

By combining our Ashurst Advance capability with a market-leading team of energy and infrastructure finance lawyers, who have experience of advising companies, investors and financial institutions on some of the most challenging projects in the world, we are uniquely placed to advise you on developing a robust and effective LIBOR transition contingency and implementation plan.

Ashurst's LIBOR Transition Finance Hub

For further analysis and commentary on developments affecting global financial markets, including LIBOR transition, visit our Finance Hub.

1. In a press release on 25 February 2019 the Commission announced that a political agreement has been reached to extend the transitional period under the Benchmarks Regulation for two years until the end of 2021 for critical benchmarks and third country benchmarks: http://europa.eu/rapid/press-release_IP-19-1418_en.htm

2. www.ecb.europa.eu/paym/pdf/cons/euro_risk-free_rates/ecb.eoniatransitionreport201812.en.pdf and www.ecb.europa.eu/paym/cons/html/wg_ester_term_structure_methodology.en.html

3. On 27 July 2017, the FCA announced that it does not intend to persuade, or use its powers to compel, panel banks to submit rates to the LIBOR administrator for the calculation of LIBOR after 2021.

4. In June 2018, the Financial Stability Board identified LIBOR and EURIBOR transition as a "medium term financial stability risk"; and in September 2018, the UK Financial Conduct Authority and Prudential Regulatory Authority issued "Dear CEO" letters to major UK banks and insurers requiring them by mid-December 2018 to (a) conduct an assessment of the key risks associated with LIBOR discontinuation and details of the actions to mitigate those risks and (b) identify the Senior Manager(s) responsible for such assessment and the institution's migration plans.

5. www.isda.org/2018/09/19/isda-publishes-benchmarks-supplement/

6. www.isda.org/2018/12/10/isda-publishes-2018-benchmarks-supplement-protocol/

7. www.isda.org/2018/07/12/isda-publishes-consultation-on-benchmark-fallbacks/

8. The consultation concluded that the preferred method for determining a term rate from an overnight RFR for use in derivative contracts was compounded in arrear and for determining an adjustment spread was using a historical mean/median approach.

9. Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (EMIR).

10. 'IASB proposes targeted amendments to IFRS Standards in response to IBOR reform', International Accounting Standards Board (3 May 2019).