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UBS Investment Research
India Power Utilities
P lanning Commission: Focus on tariff hike
�� Event: draft paper on 12th Five Year Plan says Power is key for growth
The Planning Commission (the central government body for long-term planning)
has released a draft paper on the approach to the 12th Five Year Plan. This talks
about objectives and methods to be adopted by the central government for the 12th
Plan (FY13-17). The key highlights regarding the power sector are: a) 6-7%
growth in electricity demand over FY13-17; b) increased contribution of imported
coal in thermal power generation; and c) better alignment of power pricing with
costs of generation.
�� Impact: rational pricing of electricity is critical; push for tariff hikes
The draft paper highlights that regulators are not setting electricity tariffs in a
rational manner to reflect increased cost of generation. This, we believe, would
lead to a further push from the central government to states for raising tariffs. It is
in line with our view that SEBs will have to raise power tariffs. Please refer to our
sector report ‘India Power Utilities: Not all doom and gloom’ dated 25 August
2011.
�� Action: sector underperformance provides buying opportunity
Share prices of India power utilities under our coverage have corrected 35% YTD
and we think attractive buying opportunities are emerging in the sector. We prefer
companies with relatively low risk (Power Grid and NTPC) or those were we think
valuations are compelling (Lanco and Reliance Infrastructure). Investors who are
bearish on tariff hikes may prefer Power Grid, NTPC and Reliance Infrastructure.
�� Our top picks: Power Grid and Lanco
We prefer Power Grid and Lanco. We also have Buy ratings on NTPC, Tata Power
and Reliance Infra. We recently upgraded Reliance Power from Sell to Buy.
UBS view
We think the Planning Commission’s draft paper on its approach to the 12th Plan
provides a clear view on the thought process at the central government level for
the power sector in India. Since the Planning Commission is a central
government body for centralised planning, the key relevant ministries for the
power sector such as the Ministry of Power, the Ministry of Coal, the Ministry
of Environment and Forests, and the Ministry of New and Renewable Energy
(MNRE) work in consultation with the Commission.
In our view, the key messages are:
1) The importance of electricity as a key input of India’s GDP growth is
absolutely critical.
2) States are unlikely to receive help from the central government and the
states themselves have to address the issue of lowering SEB losses.
3) SEBs have to continue with tariff hikes and would also need to take less
direct measures such as the use of distribution franchises (where the
distribution is privatised for a specific duration i.e. 10-15 years).
4) The central government is serious about reducing environmental
clearance-related hurdles for the development of coal blocks.
Key messages from draft paper on 12th Plan
Please note that the Planning Commission acts as a central advisory body for
long-term planning by the central government. The key messages from the draft
paper on the approach for the 12th Plan are as follows:
1) For GDP to grow at 9%, commercial energy supplies will have to grow at a
rate between 6.5-7% per year. Since India’s domestic energy supplies are
limited, dependence upon imports will increase. Even in the case of coal, import
dependence is projected to increase as the growth of thermal generation will
require coal supplies, which cannot be fully met from domestic mines.
2) Rational energy pricing is critical for both effective demand management and
a healthy supply response. It is relevant for demand management because energy
users have no incentive to economise if energy is under-priced. It is also relevant
for expansion of domestic supply, because under-pricing of energy imposes a
large burden on the energy producers, reducing the resources that should accrue
to them for financing new investments in these areas.
3) Regulators, often under political pressure, are not setting tariffs in a rational
manner to reflect normative costs. It must be emphasised that the country’s
ability to sustain high growth in the 12th Plan will depend critically upon its
ability to make this adjustment.
Coal prices
Coal prices are theoretically decontrolled, but in fact they are adjusted only in
consultation with the Ministry. Indian coal has high mineral content and a lower
calorific value compared to imported coal, but even accounting for this
difference, the price of domestic coal is 30-50% lower than imported coal. The
expected demand for coal from the power sector cannot be met except through a
significant increase in imports, which poses two problems. First, Indian power
plants are not designed to take more than 10-15% of imported coal. Besides,
power producers are not willing to accept higher cost fuel because that puts
them at a disadvantage compared with producers using domestic coal. It is
essential to develop some mechanism to provide power producers with a mix of
domestic and imported coal consistent with their technical constraints so that the
higher cost of imported coal is averaged with the lower cost of domestic coal.
Electricity prices
Electricity to the consumer is also under-priced. Electricity prices are set by
State regulators but most regulators have shown a tendency to hold back tariff
adjustments, typically under political pressure. At times, the distribution
companies (discoms) are also discouraged from seeking tariff revisions. The
result is that electricity tariffs are lower than they should be for many categories
of consumers over and above that of agriculture, which jeopardises the financial
position of the discoms.
A transition to more rational energy pricing requires upward adjustment in all
these prices. Since different Ministries are involved, a coordinated view is
necessary based on a holistic understanding of the rationale of the move. The
adjustment needed cannot be achieved in one go, but the process must begin so
that a full adjustment occurs over two or three years. Increasing prices is never
easy, but it is also true that the country’s ability to grow rapidly in a world of
high energy prices depends crucially on its ability to adjust to these prices.
Suppressing energy prices will not help. There is a case for insulating the poor
from these price increases by a targeted subsidy but what we have at present is a
much more general subsidy.
How much electricity supply needs to grow?
Power generation (utilities + captive) has grown at 5.8% per annum during the
period 1990-91 to 2010-11 and the implicit elasticity with respect to GDP is
0.87. This is much lower than the 1.09 recorded in the period 1993-94 to 2003-
04. It is estimated that in order to sustain GDP growth at 9%, the demand for
grid power will grow 6% per annum to 1,200 billion units by the end of the
Twelfth Plan. If liquid fuel-based captive generation is to be curtailed, as it
should be for energy efficiency, the country has to plan for grid supply of at
least 1,350 billion units
Capacity addition
The Eleventh Plan had targeted creation of 78.7 GW of additional capacity for
grid power. Actual realization may not exceed 50 GW, largely on account of
slippages in projects. The shortfall in achieving the targets has been primarily
due to poor project implementation, inadequate domestic manufacturing
capacity, shortage of power equipment, and slowdown due to lack of fuel,
particularly coal. However, more than 80,000 MW of new power capacity is
already under construction. Hence, it may be reasonable to target 100,000 MW
(100 GW) of new power capacity during the next Plan (12th Plan over FY13-17).
These will, however, need an effective resolution of issues holding up domestic
production of coal and effective measures for improving the financial health of
power utilities. The Twelfth Plan should, therefore, aim at capacity creation of
about 100 GW, which will include 28 GW of capacity from projects that were
supposed to be completed in the Eleventh Plan, but are now expected to be
completed in the first two years of the Twelfth Plan. The country must ensure
that not only the spill-over projects from the Eleventh Plan are completed at the
earliest, but those slippages in the capacity addition programme for the Twelfth
Plan are minimised. In addition, the country should examine whether it is
possible to back additional gas-based power capacity for initiation/completion
during the Twelfth Plan, given the competing demand from the fertiliser sector.
The share of the private sector in capacity expansion has gone up substantially
in the Eleventh Plan and it is expected that 33% of the total incremental capacity
will come from the private sector. In the Twelfth Plan, this share is expected to
increase further to about 50%. Since most of the new power capacity will consist
of thermal plants, it is essential to ensure that coal availability does not become
a constraint.
India has substantial potential for creating hydro power capacity, especially in
the North Eastern region. The pace of capacity creation in this area has been
slow and it is vital that special emphasis be given to expedite environmental and
other clearances, so that the pace of work on these hydro-electric power projects
can be stepped up. Early completion of these projects will also generate an
income stream for the North Eastern states, which will enable them to accelerate
the pace of development.
It is also necessary to take measures to increase the share of gas-based power
and also of nuclear power. Safeguards with respect to the latter will be further
reviewed and additional measures taken as required. As per the Commission,
both these are areas with great potential and will need investments.
Transmission
In order to support the large expansion in consumption and production of
electricity, the transmission and distribution network will have to be
significantly expanded and strengthened. Some private sector investments have
been made in transmission in the Eleventh Plan and it is important to build a
policy framework within which more private sector investments will be
forthcoming in the Twelfth Plan. A special project on power evacuation from
the North-East will have to be undertaken. The possibility of such lines passing
through Bangladesh could be considered reflecting our mutually beneficial inter
dependence. Technological development for transmission lines of 765 KV and
over 1,000/1,200 KV is of great relevance in order to reduce land requirement
and also transmission losses.
Distribution
The distribution segment in the power sector is clearly the weakest link in the
power system. The current losses of distribution utilities before accounting for
State subsidy are approximately Rs700bn. Continuation of losses on this scale is
simply not viable. There are three elements that explain these large losses:
1) State power regulators have, in most cases, lagged in setting power
tariffs annually as they were supposed to. This is largely a reflection of
political pressure on the regulators and in some cases, also of political
pressure on the utilities themselves to ensure that they do not ask for
tariff revision.
2) The supply of free or virtually free power to the farm sector, and its
mostly un-metered nature, is leading to considerable leakage.
3) State-owned power utilities have tolerated large losses, often reflecting
collusion between the distribution staff and consumers.
They have not made investments needed on the transmission side to reduce
losses and have also not fully used the meters that have been installed under the
meterisation programme, to identify and rectify power leakage.
Since the financial viability of the power sector as a whole depends upon the
revenues collected at the distribution end, it is absolutely vital that the
distribution system is made financially viable during the Twelfth Plan. This can
be done within the existing system of publicly owned distribution system by
bringing in modern systems of management, use of IT, and enforcement of
accountability.
Another way is to go in for privatisation as some states have done. Delhi, for
example, has privatised the distribution segment with good results in terms of
reduction in AT&C losses. Other states have resorted to “franchising” in which
a private company takes over the management of the distribution system and
collection of revenues on the basis of a predetermined revenue-sharing model.
Franchising has given good results in several areas, and the experiment is being
replicated.
Since distribution is entirely in the domain of the states, action to improve
distribution has to be taken by the state government. As per the Planning
Commission, states should give this issue high priority. The central government
can at best incentivise action in a manner that allows the states room for
experimenting with all the different ways of obtaining better results.
With new capacities being set up in different states, it is essential that the
country moves to operationalise the Open Access policy. Although the
introduction of Open Access has been mandated in the Electricity Act, 2003,
there has been reluctance on the part of the states to give freedom to customers
having requirement of 1 MVA and above to choose their own sources of supply.
According to the Planning Commission, this should be expedited so that power
markets are widened and deepened.
Rural Electrification
Access to power has been particularly poor in rural habitations and the Rajiv
Gandhi Grameen Vidyutikaran Yojana (RGGVY) was devised to remedy this
problem by providing connections to all villages and free connections to below
poverty line (BPL) families. There are, however, still a large number of
habitations left uncovered and a very large population that has no connectivity.
It is desirable to try and universalize access of power during the Twelfth Plan
and this requires dealing with the large backlog in the states of Uttar Pradesh,
Bihar, Orissa and Assam, and some of the other North Eastern states.
However, for effective universal access, the RGGVY programme has to be
restructured. Connectivity by itself is only part of the problem, since in many
states there is also a real shortage of power. Besides, RGGVY focuses only on
household supply and does not address the need for providing electricity for
agriculture, which needs three phase supply. This in turn requires strengthening
of the rural network, and not just last-mile connectivity to households, which is
what RGGVY covers.
There are other schemes, which provide electrical connectivity to people below
poverty line. Solar lanterns have been distributed at subsidised rates. There is
also an initiative for developing other resources of clean energy for both rural
and urban consumption. As per the Planning Commission, these programmes
need to be widened and strengthened.
Coal availability
The demand for coal has risen by about 8% per annum during the Eleventh Plan
and the Planning Commission believes it could continue to grow at the same rate
during the Twelfth Plan. Coal output expanded at about 7% per year in the fiveyear
period of 2004-05 to 2009-10, with especially strong growth in both 2008-
09 and 2009-10. However, in 2010-11, coal production remained stagnant.
Domestic coal production was originally targeted to reach 680 MTA in the
Eleventh Plan.
This was scaled down to 630 mt in the Mid-Term Appraisal and it is now
expected to be only 554 mt. Of the 208 captive coal blocks allotted with 49
billion tonnes of reserves and production potential of 657 mt per annum, the
estimated annual production by the end of the Eleventh Plan is only 37 mt.
Given the strong growth in thermal generation projected in the Twelfth Plan, the
aggregate demand for coal at the end of the Twelfth Plan is likely to be between
900 and 1,000 million tonnes, depending upon the pace of implementation of
power capacity. As against the projected demand of 900-1,000 million metric
tonnes (mt) by the end of the Twelfth Plan, the domestic output is unlikely to
exceed 750 mt, leaving a shortfall of more than 200 mt to be met through
imports. Even this assumes that the domestic output will be able to increase by
over 200 mt from current levels.
Fuel Supply Agreements
Uncertainties in coal supply are already affecting the establishment of
generating capacity. Coal India Limited (CIL) is not entering into Fuel Supply
Arrangements for more than 50% of the requirement of thermal plants, and that
too only for five years. Private sector investors in power generation are unlikely
to be able to access financing from banks if there is uncertainty about coal
supplies. Although coal is importable, coal imports are much more expensive
and power producers are reluctant to accept a fuel supply arrangement based on
imported coal, which would put them at a disadvantage.
If domestic coal prices were aligned with world prices, this problem would not
arise. However, such a large adjustment may not be easy to achieve in a short
period. CIL should explore the possibility of developing a mechanism to enable
power producers to procure a mix of domestic and imported coal consistent with
their technical constraints. The Planning Commission believes that the country
must introduce a system of pooling domestic and imported coal prices for power
producers so that the price they are charged does not depend upon whether they
receive domestic or imported coal.
Environment constraints
According to the Planning Commission, an important reason for the low
domestic production of coal is the insufficient incentive for the states to increase
coal production. In addition, there have been, in the recent years, constraints due
to tighter environmental regulations, problems in Resettlement & Rehabilitation
(R&R), and also problems in land acquisition. The Ministry of Environment &
Forests had adopted a policy of ‘Go-No Go’, in which coal mining was
completely banned in No Go areas.
However, as large coal-bearing areas were suddenly declared ‘No Go’ areas, this
would have severely limited the ability to expand domestic production of coal.
Further, Comprehensive Environmental Pollution Index (CEPI) norms were
introduced, which prohibited mining in areas with a high pollution index, even if
the pollution was due to other industrial sources. Coal being ‘location specific’,
there is clearly a need to review this approach.
A Group of Ministers is working for the resolution of these issues and it is
essential that an appropriate balance be struck between the need to protect the
environment and the need for energy security.
Underground coal mining has potential to greatly reduce the disturbance caused
to the environment. However, current output levels from underground mining at
60 mt are very low and these mines are mostly old. There has been very little
fresh investment in underground mining. It may be necessary to sharply increase
the scope and share of underground coal mining and this will involve much
greater mechanisation and investment by private players.
Washeries
The quality of Indian coal is poor and needs to be improved through coal
washeries, which call for an expansion in washery capacity that would improve
the quality of the coal and efficiency of the consuming industries. There has
been a very marginal increase in the coal washery capacities. One reason for this
is that the system of coal pricing does not contain a sufficient premium for
higher quality coal.
As per the Planning Commission, CIL must move towards a pricing mechanism
in which coal of higher calorific value is priced with an appropriate premium. It
is also necessary to promote productive use of the large volume of washery
rejects, which contain large quantities of sensible heat.
Prospecting of coal in new areas must be undertaken. The exploration of all
known coal-bearing areas is planned to be completed during the Twelfth Plan.
This would result in expansion of the inferred/proven category and thereby,
overall availability. Environmental concerns regarding these, particularly
limitations in undertaking this work effectively in forest areas, will be addressed.
Coal imports
With the best effort at increasing domestic production, it will not be possible to
meet the increased demand for coal from domestic production. The Planning
Commission expects coal imports to rise from about 90 million tonnes at present
to over 200 million tonne from 2016-17. The necessary infrastructure including
ports and railways to service these projected import volumes will have to be in
place.
Given the importance of expanding supply and the indifferent performance of
CIL in increasing production, there is need for inducting private sector
investment in coal. It is already allowed for captive mining. There is no reason
why it should not be opened up generally. In this context, there is a case for
reconsidering the merit of nationalisation of the industry.
Renewable energy
As per the Planning Commission, continued emphasis has to be placed on other
renewable resources, especially on expanding wind power generation and in the
emerging area of solar thermal and solar photovoltaic. While a National Solar
Mission plans for a capacity of 22,000 MW by 2022, the Centre for Wind
Energy Technology (CWET) estimated a technically feasible wind potential of
49,000 MW. A fresh assessment of wind power potential by some agencies has
mentioned a higher figure, which needs realistic review by the MNRE based on
the scientific norms.
These areas will need further study. The potential for such generation is clearly
higher than current estimates of about 50 GW. Appropriate measures must be
devised to strengthen a policy framework to use this, according to the Planning
Commission.
It is also necessary that scientific and technological developments, especially in
the solar energy field, are sufficiently internalised to keep the country abreast of
international developments. In order to make solar power a success in the
coming decades, it is vital that the country develop the necessary technology
such that it can collaborate as peers with the rest of the global community.
A basic problem with most renewable energy sources is that they are
significantly more expensive than conventional power. However, technological
developments are reducing the cost of renewable generation and it is widely
predicted that by 2019 the cost of solar electricity generation, which is currently
six times higher than coal-based electricity will come down to be approximately
equal to the latter.
However, this equalisation is expected to occur partly because the cost of
conventional fuels is expected to rise significantly. In other words, technological
developments in the field of renewable energy will help overcome energy
constraints, but only at significantly higher energy prices. This underscores the
fact that in the medium term, energy prices in India must rise to correspond
more closely with world energy prices.
The overview of energy-related issues presented in this chapter shows that a
workable energy strategy for the Twelfth Plan requires a large number of actions
by different Ministries in the central government plus action by state
governments in several areas.
The success of the Twelfth Plan depends critically on the country’s being able to
ensure that all or most of these actions are taken within a reasonable period of
time. Unless this can be done, energy constraints will likely limit the ability of
the economy to reach 9% growth.
The implications
We think tariffs need to rise
We think the SEBs have been trying to lower their losses. We believe the tariffs
can be adequately raised to cover costs and lower losses as this is more a
question of political will from the state governments. We also believe that the
electorate understands that tariff hikes are a reality. For instance, over the past
ten years, prices of all the other basic and essential commodities such as salt,
wheat, rice, pulses and kerosene have increased more rapidly than electricity.
During the tariff hikes over the past six to 12 months, resistance from the
opposition political parties has been manageable for the local governments.
Another key factor supporting tariff hikes is that among the state governments,
there was hope that the central government would help the SEBs if things do not
improve. The Power Ministry and the Planning Commission have informed the
states in clear terms that this is now highly unlikely.
Please refer to our sector report ‘India Power Utilities: Not all doom and gloom’
dated 25 August 2011.
States are raising tariffs
While investor sentiment has been negative, we think understanding the
importance of electricity as a political issue and a key input of India’s GDP
growth is vital in forming a view on India’s power sector. A prolonged
electricity shortage could have serious consequences for the political class and
might lead to a backlash during the elections. The infrastructure development
agenda is a central one and recent elections indicate that electricity, roads, and
water have become the main issues for election campaigns.
Based on our discussions with various decision-making bodies (Ministry of
Power, Ministry of Coal, Central Electricity Authority (CEA), Central
Electricity Regulatory Authority (CERC), and the Planning Commission), we
think the state governments have started to address the SEBs’ losses (as the
central government is unlikely to bail them out). We think some state
governments such as Bihar, Punjab and Karnataka have shown the political will
to tackle these issues.
Many state governments have moved forward on power tariff hikes. Of the 28
states in India, at least 16 states (more than 80% of total consumption) have
either implemented or proposed power tariff hikes over the past six months.
The key states where tariffs have been revised or will be revised are: Karnataka
(22%), Delhi (22%), Rajasthan (20%), Orissa (20%), Bihar (19%), Jharkhand
(16%), Assam (14%), and Chhattisgarh (14%).
Table 2: Tariff hikes across states
State Tariff hike
Karnataka 22%
Delhi 22%
Rajasthan 20%
Orissa 20%
Bihar 19%
Jharkhand 16%
Assam 14%
Chhattisgarh 14%
Andhra Pradesh 12%
Punjab 9%
West Bengal 9%
Gujarat 8%
Madhya Pradesh 6%
Uttarakhand 5%
Maharashtra 5%
Haryana 3%
Source: UBS
Please refer to our sector report ‘India Power Utilities: More positive newsflow
on tariff hikes’ dated 7 September 2011.
Central government may not bail out SEBs
Based on our discussions with senior officials from the Ministry of Power, the
Planning Commission, and other participants in the decision-making process
(Ministry of Coal, CEA, and CERC), we believe the central government is
unwilling to make any concessions to the states and their electricity boards.
Without help from the central government, the SEBs will have no choice but to
become more financially disciplined.
During the State Power Ministers’ Conference on ‘Distribution Sector Reforms’ in
New Delhi in July 2011, the Union Power Minister and Deputy Chairman of the
Planning Commission highlighted the need to lower distribution losses to the state
power ministers. The following set of measures to lower the distribution losses
were agreed on during the conference.
(1) The state governments will ensure that the utilities’ accounts are audited up
to 2009-10 and ensure the accounts for a financial year are audited by
September of the next financial year, henceforth. The computerisation of
accounts will be made a priority, if not already.
(2) The states will ensure that the distribution utilities file their annual tariff
revision petitions each year by December-January of the preceding
financial year to the state regulators, as stipulated by the National Tariff
Policy.
(3) The annual tariff revision petition will be filed before the State Electricity
Regulatory Commission (SERC), keeping in view the increase in power
purchase costs (which account for 70-80% of the cost of supply), while the
states will ensure that the difference between average revenue requirements
(ARR) and the average cost of supply (ACS) will not only be bridged, but
will generate internal surpluses that can be used for network expansions
and maintenance.
(4) The state governments will ensure automatic pass-through in tariffs for any
fuel cost increases by incorporating the pass-through in the regulations, as
provided in Section 62(4) of the Electricity Act, 2003 (the state
governments can issue directions to SERCs under Section 108 of the
Electricity Act, 2003).
(5) The state governments will not only clear all outstanding subsidies to the
utilities, but also ensure advance payments of subsidies are made in future,
as per Section 65 of the Electricity Act, 2003.
(6) The eligibility criteria for the inclusion of towns under the restructured
accelerated power development and reform programme (R-APDRP)
assistance with a population of 30,000 (10,000 for special category states)
should be reduced to 15,000 (5,000 for special category states). All district
headquarter towns in the special category states should also be covered
under the R-APDRP, irrespective of their population sizes.
(7) The state governments will ensure the payment of all outstanding dues
from its various departments and institutions to the distribution utilities, or
release payments from the state budget directly.
(8) The state governments will consider converting loans due from the SEBs to
equity (this will improve the utilities’ net worth).
(9) The state governments will take steps to reduce AT&C losses to less than
15% through administrative measures, curbing the pilferage of electricity,
and establishing special police stations and courts to deal exclusively with
power theft-related cases, if they have not done so already.
(10) The states will immediately initiate steps to appoint distribution franchises
in the urban areas through a competitive bidding process.
(11) The states will immediately invite bids to meet the non-covered generation
capacity gap with regard to their requirements by the end of the 12th Five
Year Plan. The process should be completed by March 2012.
(12) The states will create units for the integrated planning of power generation,
transmission and distribution to meet their own future requirements.
These measures are in line with our view that the central government, the
Ministry of Power, and the Planning Commission have become more proactive
in lowering power distribution losses. We believe it will ultimately be the states’
willingness and proactive measures that will decide the future of distribution
reforms in India. Hence, the central government’s role could be limited. Overall,
we believe there have been positive changes over the past six months in the form
of tariff hikes at the state level.
�� Statement of Risk
In the Indian power sector, we believe the key risks for companies are regulatory,
execution related, funding availability and interest rates.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
UBS Investment Research
India Power Utilities
P lanning Commission: Focus on tariff hike
�� Event: draft paper on 12th Five Year Plan says Power is key for growth
The Planning Commission (the central government body for long-term planning)
has released a draft paper on the approach to the 12th Five Year Plan. This talks
about objectives and methods to be adopted by the central government for the 12th
Plan (FY13-17). The key highlights regarding the power sector are: a) 6-7%
growth in electricity demand over FY13-17; b) increased contribution of imported
coal in thermal power generation; and c) better alignment of power pricing with
costs of generation.
�� Impact: rational pricing of electricity is critical; push for tariff hikes
The draft paper highlights that regulators are not setting electricity tariffs in a
rational manner to reflect increased cost of generation. This, we believe, would
lead to a further push from the central government to states for raising tariffs. It is
in line with our view that SEBs will have to raise power tariffs. Please refer to our
sector report ‘India Power Utilities: Not all doom and gloom’ dated 25 August
2011.
�� Action: sector underperformance provides buying opportunity
Share prices of India power utilities under our coverage have corrected 35% YTD
and we think attractive buying opportunities are emerging in the sector. We prefer
companies with relatively low risk (Power Grid and NTPC) or those were we think
valuations are compelling (Lanco and Reliance Infrastructure). Investors who are
bearish on tariff hikes may prefer Power Grid, NTPC and Reliance Infrastructure.
�� Our top picks: Power Grid and Lanco
We prefer Power Grid and Lanco. We also have Buy ratings on NTPC, Tata Power
and Reliance Infra. We recently upgraded Reliance Power from Sell to Buy.
UBS view
We think the Planning Commission’s draft paper on its approach to the 12th Plan
provides a clear view on the thought process at the central government level for
the power sector in India. Since the Planning Commission is a central
government body for centralised planning, the key relevant ministries for the
power sector such as the Ministry of Power, the Ministry of Coal, the Ministry
of Environment and Forests, and the Ministry of New and Renewable Energy
(MNRE) work in consultation with the Commission.
In our view, the key messages are:
1) The importance of electricity as a key input of India’s GDP growth is
absolutely critical.
2) States are unlikely to receive help from the central government and the
states themselves have to address the issue of lowering SEB losses.
3) SEBs have to continue with tariff hikes and would also need to take less
direct measures such as the use of distribution franchises (where the
distribution is privatised for a specific duration i.e. 10-15 years).
4) The central government is serious about reducing environmental
clearance-related hurdles for the development of coal blocks.
Key messages from draft paper on 12th Plan
Please note that the Planning Commission acts as a central advisory body for
long-term planning by the central government. The key messages from the draft
paper on the approach for the 12th Plan are as follows:
1) For GDP to grow at 9%, commercial energy supplies will have to grow at a
rate between 6.5-7% per year. Since India’s domestic energy supplies are
limited, dependence upon imports will increase. Even in the case of coal, import
dependence is projected to increase as the growth of thermal generation will
require coal supplies, which cannot be fully met from domestic mines.
2) Rational energy pricing is critical for both effective demand management and
a healthy supply response. It is relevant for demand management because energy
users have no incentive to economise if energy is under-priced. It is also relevant
for expansion of domestic supply, because under-pricing of energy imposes a
large burden on the energy producers, reducing the resources that should accrue
to them for financing new investments in these areas.
3) Regulators, often under political pressure, are not setting tariffs in a rational
manner to reflect normative costs. It must be emphasised that the country’s
ability to sustain high growth in the 12th Plan will depend critically upon its
ability to make this adjustment.
Coal prices
Coal prices are theoretically decontrolled, but in fact they are adjusted only in
consultation with the Ministry. Indian coal has high mineral content and a lower
calorific value compared to imported coal, but even accounting for this
difference, the price of domestic coal is 30-50% lower than imported coal. The
expected demand for coal from the power sector cannot be met except through a
significant increase in imports, which poses two problems. First, Indian power
plants are not designed to take more than 10-15% of imported coal. Besides,
power producers are not willing to accept higher cost fuel because that puts
them at a disadvantage compared with producers using domestic coal. It is
essential to develop some mechanism to provide power producers with a mix of
domestic and imported coal consistent with their technical constraints so that the
higher cost of imported coal is averaged with the lower cost of domestic coal.
Electricity prices
Electricity to the consumer is also under-priced. Electricity prices are set by
State regulators but most regulators have shown a tendency to hold back tariff
adjustments, typically under political pressure. At times, the distribution
companies (discoms) are also discouraged from seeking tariff revisions. The
result is that electricity tariffs are lower than they should be for many categories
of consumers over and above that of agriculture, which jeopardises the financial
position of the discoms.
A transition to more rational energy pricing requires upward adjustment in all
these prices. Since different Ministries are involved, a coordinated view is
necessary based on a holistic understanding of the rationale of the move. The
adjustment needed cannot be achieved in one go, but the process must begin so
that a full adjustment occurs over two or three years. Increasing prices is never
easy, but it is also true that the country’s ability to grow rapidly in a world of
high energy prices depends crucially on its ability to adjust to these prices.
Suppressing energy prices will not help. There is a case for insulating the poor
from these price increases by a targeted subsidy but what we have at present is a
much more general subsidy.
How much electricity supply needs to grow?
Power generation (utilities + captive) has grown at 5.8% per annum during the
period 1990-91 to 2010-11 and the implicit elasticity with respect to GDP is
0.87. This is much lower than the 1.09 recorded in the period 1993-94 to 2003-
04. It is estimated that in order to sustain GDP growth at 9%, the demand for
grid power will grow 6% per annum to 1,200 billion units by the end of the
Twelfth Plan. If liquid fuel-based captive generation is to be curtailed, as it
should be for energy efficiency, the country has to plan for grid supply of at
least 1,350 billion units
Capacity addition
The Eleventh Plan had targeted creation of 78.7 GW of additional capacity for
grid power. Actual realization may not exceed 50 GW, largely on account of
slippages in projects. The shortfall in achieving the targets has been primarily
due to poor project implementation, inadequate domestic manufacturing
capacity, shortage of power equipment, and slowdown due to lack of fuel,
particularly coal. However, more than 80,000 MW of new power capacity is
already under construction. Hence, it may be reasonable to target 100,000 MW
(100 GW) of new power capacity during the next Plan (12th Plan over FY13-17).
These will, however, need an effective resolution of issues holding up domestic
production of coal and effective measures for improving the financial health of
power utilities. The Twelfth Plan should, therefore, aim at capacity creation of
about 100 GW, which will include 28 GW of capacity from projects that were
supposed to be completed in the Eleventh Plan, but are now expected to be
completed in the first two years of the Twelfth Plan. The country must ensure
that not only the spill-over projects from the Eleventh Plan are completed at the
earliest, but those slippages in the capacity addition programme for the Twelfth
Plan are minimised. In addition, the country should examine whether it is
possible to back additional gas-based power capacity for initiation/completion
during the Twelfth Plan, given the competing demand from the fertiliser sector.
The share of the private sector in capacity expansion has gone up substantially
in the Eleventh Plan and it is expected that 33% of the total incremental capacity
will come from the private sector. In the Twelfth Plan, this share is expected to
increase further to about 50%. Since most of the new power capacity will consist
of thermal plants, it is essential to ensure that coal availability does not become
a constraint.
India has substantial potential for creating hydro power capacity, especially in
the North Eastern region. The pace of capacity creation in this area has been
slow and it is vital that special emphasis be given to expedite environmental and
other clearances, so that the pace of work on these hydro-electric power projects
can be stepped up. Early completion of these projects will also generate an
income stream for the North Eastern states, which will enable them to accelerate
the pace of development.
It is also necessary to take measures to increase the share of gas-based power
and also of nuclear power. Safeguards with respect to the latter will be further
reviewed and additional measures taken as required. As per the Commission,
both these are areas with great potential and will need investments.
Transmission
In order to support the large expansion in consumption and production of
electricity, the transmission and distribution network will have to be
significantly expanded and strengthened. Some private sector investments have
been made in transmission in the Eleventh Plan and it is important to build a
policy framework within which more private sector investments will be
forthcoming in the Twelfth Plan. A special project on power evacuation from
the North-East will have to be undertaken. The possibility of such lines passing
through Bangladesh could be considered reflecting our mutually beneficial inter
dependence. Technological development for transmission lines of 765 KV and
over 1,000/1,200 KV is of great relevance in order to reduce land requirement
and also transmission losses.
Distribution
The distribution segment in the power sector is clearly the weakest link in the
power system. The current losses of distribution utilities before accounting for
State subsidy are approximately Rs700bn. Continuation of losses on this scale is
simply not viable. There are three elements that explain these large losses:
1) State power regulators have, in most cases, lagged in setting power
tariffs annually as they were supposed to. This is largely a reflection of
political pressure on the regulators and in some cases, also of political
pressure on the utilities themselves to ensure that they do not ask for
tariff revision.
2) The supply of free or virtually free power to the farm sector, and its
mostly un-metered nature, is leading to considerable leakage.
3) State-owned power utilities have tolerated large losses, often reflecting
collusion between the distribution staff and consumers.
They have not made investments needed on the transmission side to reduce
losses and have also not fully used the meters that have been installed under the
meterisation programme, to identify and rectify power leakage.
Since the financial viability of the power sector as a whole depends upon the
revenues collected at the distribution end, it is absolutely vital that the
distribution system is made financially viable during the Twelfth Plan. This can
be done within the existing system of publicly owned distribution system by
bringing in modern systems of management, use of IT, and enforcement of
accountability.
Another way is to go in for privatisation as some states have done. Delhi, for
example, has privatised the distribution segment with good results in terms of
reduction in AT&C losses. Other states have resorted to “franchising” in which
a private company takes over the management of the distribution system and
collection of revenues on the basis of a predetermined revenue-sharing model.
Franchising has given good results in several areas, and the experiment is being
replicated.
Since distribution is entirely in the domain of the states, action to improve
distribution has to be taken by the state government. As per the Planning
Commission, states should give this issue high priority. The central government
can at best incentivise action in a manner that allows the states room for
experimenting with all the different ways of obtaining better results.
With new capacities being set up in different states, it is essential that the
country moves to operationalise the Open Access policy. Although the
introduction of Open Access has been mandated in the Electricity Act, 2003,
there has been reluctance on the part of the states to give freedom to customers
having requirement of 1 MVA and above to choose their own sources of supply.
According to the Planning Commission, this should be expedited so that power
markets are widened and deepened.
Rural Electrification
Access to power has been particularly poor in rural habitations and the Rajiv
Gandhi Grameen Vidyutikaran Yojana (RGGVY) was devised to remedy this
problem by providing connections to all villages and free connections to below
poverty line (BPL) families. There are, however, still a large number of
habitations left uncovered and a very large population that has no connectivity.
It is desirable to try and universalize access of power during the Twelfth Plan
and this requires dealing with the large backlog in the states of Uttar Pradesh,
Bihar, Orissa and Assam, and some of the other North Eastern states.
However, for effective universal access, the RGGVY programme has to be
restructured. Connectivity by itself is only part of the problem, since in many
states there is also a real shortage of power. Besides, RGGVY focuses only on
household supply and does not address the need for providing electricity for
agriculture, which needs three phase supply. This in turn requires strengthening
of the rural network, and not just last-mile connectivity to households, which is
what RGGVY covers.
There are other schemes, which provide electrical connectivity to people below
poverty line. Solar lanterns have been distributed at subsidised rates. There is
also an initiative for developing other resources of clean energy for both rural
and urban consumption. As per the Planning Commission, these programmes
need to be widened and strengthened.
Coal availability
The demand for coal has risen by about 8% per annum during the Eleventh Plan
and the Planning Commission believes it could continue to grow at the same rate
during the Twelfth Plan. Coal output expanded at about 7% per year in the fiveyear
period of 2004-05 to 2009-10, with especially strong growth in both 2008-
09 and 2009-10. However, in 2010-11, coal production remained stagnant.
Domestic coal production was originally targeted to reach 680 MTA in the
Eleventh Plan.
This was scaled down to 630 mt in the Mid-Term Appraisal and it is now
expected to be only 554 mt. Of the 208 captive coal blocks allotted with 49
billion tonnes of reserves and production potential of 657 mt per annum, the
estimated annual production by the end of the Eleventh Plan is only 37 mt.
Given the strong growth in thermal generation projected in the Twelfth Plan, the
aggregate demand for coal at the end of the Twelfth Plan is likely to be between
900 and 1,000 million tonnes, depending upon the pace of implementation of
power capacity. As against the projected demand of 900-1,000 million metric
tonnes (mt) by the end of the Twelfth Plan, the domestic output is unlikely to
exceed 750 mt, leaving a shortfall of more than 200 mt to be met through
imports. Even this assumes that the domestic output will be able to increase by
over 200 mt from current levels.
Fuel Supply Agreements
Uncertainties in coal supply are already affecting the establishment of
generating capacity. Coal India Limited (CIL) is not entering into Fuel Supply
Arrangements for more than 50% of the requirement of thermal plants, and that
too only for five years. Private sector investors in power generation are unlikely
to be able to access financing from banks if there is uncertainty about coal
supplies. Although coal is importable, coal imports are much more expensive
and power producers are reluctant to accept a fuel supply arrangement based on
imported coal, which would put them at a disadvantage.
If domestic coal prices were aligned with world prices, this problem would not
arise. However, such a large adjustment may not be easy to achieve in a short
period. CIL should explore the possibility of developing a mechanism to enable
power producers to procure a mix of domestic and imported coal consistent with
their technical constraints. The Planning Commission believes that the country
must introduce a system of pooling domestic and imported coal prices for power
producers so that the price they are charged does not depend upon whether they
receive domestic or imported coal.
Environment constraints
According to the Planning Commission, an important reason for the low
domestic production of coal is the insufficient incentive for the states to increase
coal production. In addition, there have been, in the recent years, constraints due
to tighter environmental regulations, problems in Resettlement & Rehabilitation
(R&R), and also problems in land acquisition. The Ministry of Environment &
Forests had adopted a policy of ‘Go-No Go’, in which coal mining was
completely banned in No Go areas.
However, as large coal-bearing areas were suddenly declared ‘No Go’ areas, this
would have severely limited the ability to expand domestic production of coal.
Further, Comprehensive Environmental Pollution Index (CEPI) norms were
introduced, which prohibited mining in areas with a high pollution index, even if
the pollution was due to other industrial sources. Coal being ‘location specific’,
there is clearly a need to review this approach.
A Group of Ministers is working for the resolution of these issues and it is
essential that an appropriate balance be struck between the need to protect the
environment and the need for energy security.
Underground coal mining has potential to greatly reduce the disturbance caused
to the environment. However, current output levels from underground mining at
60 mt are very low and these mines are mostly old. There has been very little
fresh investment in underground mining. It may be necessary to sharply increase
the scope and share of underground coal mining and this will involve much
greater mechanisation and investment by private players.
Washeries
The quality of Indian coal is poor and needs to be improved through coal
washeries, which call for an expansion in washery capacity that would improve
the quality of the coal and efficiency of the consuming industries. There has
been a very marginal increase in the coal washery capacities. One reason for this
is that the system of coal pricing does not contain a sufficient premium for
higher quality coal.
As per the Planning Commission, CIL must move towards a pricing mechanism
in which coal of higher calorific value is priced with an appropriate premium. It
is also necessary to promote productive use of the large volume of washery
rejects, which contain large quantities of sensible heat.
Prospecting of coal in new areas must be undertaken. The exploration of all
known coal-bearing areas is planned to be completed during the Twelfth Plan.
This would result in expansion of the inferred/proven category and thereby,
overall availability. Environmental concerns regarding these, particularly
limitations in undertaking this work effectively in forest areas, will be addressed.
Coal imports
With the best effort at increasing domestic production, it will not be possible to
meet the increased demand for coal from domestic production. The Planning
Commission expects coal imports to rise from about 90 million tonnes at present
to over 200 million tonne from 2016-17. The necessary infrastructure including
ports and railways to service these projected import volumes will have to be in
place.
Given the importance of expanding supply and the indifferent performance of
CIL in increasing production, there is need for inducting private sector
investment in coal. It is already allowed for captive mining. There is no reason
why it should not be opened up generally. In this context, there is a case for
reconsidering the merit of nationalisation of the industry.
Renewable energy
As per the Planning Commission, continued emphasis has to be placed on other
renewable resources, especially on expanding wind power generation and in the
emerging area of solar thermal and solar photovoltaic. While a National Solar
Mission plans for a capacity of 22,000 MW by 2022, the Centre for Wind
Energy Technology (CWET) estimated a technically feasible wind potential of
49,000 MW. A fresh assessment of wind power potential by some agencies has
mentioned a higher figure, which needs realistic review by the MNRE based on
the scientific norms.
These areas will need further study. The potential for such generation is clearly
higher than current estimates of about 50 GW. Appropriate measures must be
devised to strengthen a policy framework to use this, according to the Planning
Commission.
It is also necessary that scientific and technological developments, especially in
the solar energy field, are sufficiently internalised to keep the country abreast of
international developments. In order to make solar power a success in the
coming decades, it is vital that the country develop the necessary technology
such that it can collaborate as peers with the rest of the global community.
A basic problem with most renewable energy sources is that they are
significantly more expensive than conventional power. However, technological
developments are reducing the cost of renewable generation and it is widely
predicted that by 2019 the cost of solar electricity generation, which is currently
six times higher than coal-based electricity will come down to be approximately
equal to the latter.
However, this equalisation is expected to occur partly because the cost of
conventional fuels is expected to rise significantly. In other words, technological
developments in the field of renewable energy will help overcome energy
constraints, but only at significantly higher energy prices. This underscores the
fact that in the medium term, energy prices in India must rise to correspond
more closely with world energy prices.
The overview of energy-related issues presented in this chapter shows that a
workable energy strategy for the Twelfth Plan requires a large number of actions
by different Ministries in the central government plus action by state
governments in several areas.
The success of the Twelfth Plan depends critically on the country’s being able to
ensure that all or most of these actions are taken within a reasonable period of
time. Unless this can be done, energy constraints will likely limit the ability of
the economy to reach 9% growth.
The implications
We think tariffs need to rise
We think the SEBs have been trying to lower their losses. We believe the tariffs
can be adequately raised to cover costs and lower losses as this is more a
question of political will from the state governments. We also believe that the
electorate understands that tariff hikes are a reality. For instance, over the past
ten years, prices of all the other basic and essential commodities such as salt,
wheat, rice, pulses and kerosene have increased more rapidly than electricity.
During the tariff hikes over the past six to 12 months, resistance from the
opposition political parties has been manageable for the local governments.
Another key factor supporting tariff hikes is that among the state governments,
there was hope that the central government would help the SEBs if things do not
improve. The Power Ministry and the Planning Commission have informed the
states in clear terms that this is now highly unlikely.
Please refer to our sector report ‘India Power Utilities: Not all doom and gloom’
dated 25 August 2011.
States are raising tariffs
While investor sentiment has been negative, we think understanding the
importance of electricity as a political issue and a key input of India’s GDP
growth is vital in forming a view on India’s power sector. A prolonged
electricity shortage could have serious consequences for the political class and
might lead to a backlash during the elections. The infrastructure development
agenda is a central one and recent elections indicate that electricity, roads, and
water have become the main issues for election campaigns.
Based on our discussions with various decision-making bodies (Ministry of
Power, Ministry of Coal, Central Electricity Authority (CEA), Central
Electricity Regulatory Authority (CERC), and the Planning Commission), we
think the state governments have started to address the SEBs’ losses (as the
central government is unlikely to bail them out). We think some state
governments such as Bihar, Punjab and Karnataka have shown the political will
to tackle these issues.
Many state governments have moved forward on power tariff hikes. Of the 28
states in India, at least 16 states (more than 80% of total consumption) have
either implemented or proposed power tariff hikes over the past six months.
The key states where tariffs have been revised or will be revised are: Karnataka
(22%), Delhi (22%), Rajasthan (20%), Orissa (20%), Bihar (19%), Jharkhand
(16%), Assam (14%), and Chhattisgarh (14%).
Table 2: Tariff hikes across states
State Tariff hike
Karnataka 22%
Delhi 22%
Rajasthan 20%
Orissa 20%
Bihar 19%
Jharkhand 16%
Assam 14%
Chhattisgarh 14%
Andhra Pradesh 12%
Punjab 9%
West Bengal 9%
Gujarat 8%
Madhya Pradesh 6%
Uttarakhand 5%
Maharashtra 5%
Haryana 3%
Source: UBS
Please refer to our sector report ‘India Power Utilities: More positive newsflow
on tariff hikes’ dated 7 September 2011.
Central government may not bail out SEBs
Based on our discussions with senior officials from the Ministry of Power, the
Planning Commission, and other participants in the decision-making process
(Ministry of Coal, CEA, and CERC), we believe the central government is
unwilling to make any concessions to the states and their electricity boards.
Without help from the central government, the SEBs will have no choice but to
become more financially disciplined.
During the State Power Ministers’ Conference on ‘Distribution Sector Reforms’ in
New Delhi in July 2011, the Union Power Minister and Deputy Chairman of the
Planning Commission highlighted the need to lower distribution losses to the state
power ministers. The following set of measures to lower the distribution losses
were agreed on during the conference.
(1) The state governments will ensure that the utilities’ accounts are audited up
to 2009-10 and ensure the accounts for a financial year are audited by
September of the next financial year, henceforth. The computerisation of
accounts will be made a priority, if not already.
(2) The states will ensure that the distribution utilities file their annual tariff
revision petitions each year by December-January of the preceding
financial year to the state regulators, as stipulated by the National Tariff
Policy.
(3) The annual tariff revision petition will be filed before the State Electricity
Regulatory Commission (SERC), keeping in view the increase in power
purchase costs (which account for 70-80% of the cost of supply), while the
states will ensure that the difference between average revenue requirements
(ARR) and the average cost of supply (ACS) will not only be bridged, but
will generate internal surpluses that can be used for network expansions
and maintenance.
(4) The state governments will ensure automatic pass-through in tariffs for any
fuel cost increases by incorporating the pass-through in the regulations, as
provided in Section 62(4) of the Electricity Act, 2003 (the state
governments can issue directions to SERCs under Section 108 of the
Electricity Act, 2003).
(5) The state governments will not only clear all outstanding subsidies to the
utilities, but also ensure advance payments of subsidies are made in future,
as per Section 65 of the Electricity Act, 2003.
(6) The eligibility criteria for the inclusion of towns under the restructured
accelerated power development and reform programme (R-APDRP)
assistance with a population of 30,000 (10,000 for special category states)
should be reduced to 15,000 (5,000 for special category states). All district
headquarter towns in the special category states should also be covered
under the R-APDRP, irrespective of their population sizes.
(7) The state governments will ensure the payment of all outstanding dues
from its various departments and institutions to the distribution utilities, or
release payments from the state budget directly.
(8) The state governments will consider converting loans due from the SEBs to
equity (this will improve the utilities’ net worth).
(9) The state governments will take steps to reduce AT&C losses to less than
15% through administrative measures, curbing the pilferage of electricity,
and establishing special police stations and courts to deal exclusively with
power theft-related cases, if they have not done so already.
(10) The states will immediately initiate steps to appoint distribution franchises
in the urban areas through a competitive bidding process.
(11) The states will immediately invite bids to meet the non-covered generation
capacity gap with regard to their requirements by the end of the 12th Five
Year Plan. The process should be completed by March 2012.
(12) The states will create units for the integrated planning of power generation,
transmission and distribution to meet their own future requirements.
These measures are in line with our view that the central government, the
Ministry of Power, and the Planning Commission have become more proactive
in lowering power distribution losses. We believe it will ultimately be the states’
willingness and proactive measures that will decide the future of distribution
reforms in India. Hence, the central government’s role could be limited. Overall,
we believe there have been positive changes over the past six months in the form
of tariff hikes at the state level.
�� Statement of Risk
In the Indian power sector, we believe the key risks for companies are regulatory,
execution related, funding availability and interest rates.
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