The next 10 years just could belong to reducing costs and tariffs, and therefore to innovation. As Kameswara Rao and Rahul Raizada analyse, private participation in general will stand to gain overall. Here is a nose-to-the-ground analysis of what 2011 has in store.
The future for the power sector remains positive, with deepening of private participation in all segments of the industry at the same time, possibly for the first time since 1991. There is an improving appreciation of the sector's issues by regulators and policy makers and this may help in addressing challenges that lie ahead. It is expected that public and private sector participants will capitalise on gains achieved and with continued investments in the sectors, it will lead to a sustainable change in the sector. The opportunities that lie ahead in 2011 for the sector are aplenty, as is what remains to be done.
T&D: Bridging the last mile
The ongoing strengthening of the national grid and regional inter-connectivity are significant watershed events, enabling energy trading, improving plant and system utilisation and helping maintain the flow of investment. There is much work still to be done at the state level where investment for evacuation and upgradation projects are considerable and private participation through the independent private transmission company route is needed more seriously. In 2010 we've seen the handover of the East-North interconnection project (to Sterlite Technologies) and North Karanpura and Talcher II transmission strengthening projects (both to Reliance Power Transmission), and bidding recently concluded for the Raichur-Solapur line. In addition to the ongoing central projects, we expect to see some state-level IPTC tendered this year.
Interestingly, the recent IPTC tenders have thrown up very competitive offers with lessons for the future. The easing of qualifying requirements has attracted a large response and has let a wide range of strategies come into play, in terms of EPC procurement, financing and income optimisation. The resulting tariffs quoted, however, still span a wide range, with quotes running 2.1-3.2 times over preferred bidders. Going forward, as live experience from work on projects tendered comes in, we expect to see more nuanced bid responses.
The value generated by the power sector is drained by continued underperformance of the distribution and retail supply business, with has a combined commercial deficit of $9 billion (2009), representing a loss of 91 paisa per kWh sold. The sector's growth story can come to a grinding halt, with potential losses to exchequer, banks, mutual funds and insurance companies, and to the legions of small investors in the growing number of listed power companies, unless early signs are taken seriously to address the sector's fundamental viability concerns. The required action is on three fronts—cost recovery through tariffs, effective targeting of subsidy and improvement in operational efficiency.
The retail tariffs have failed to keep pace with rise in cost of primary energy in the last three to four years, and with political action forcing tariffs to remain unchanged for a decade or so in some states, responding to the recent reality will not be easy. It is important for regulators to appreciate the rise in global energy and commodity prices and the need for licensees to be viable to serve their consumers, and accordingly permit tariff coverage consistently, even if it is on an incremental basis, such as through fuel escalation pass-through. This was to be achieved through multi-year tariffs, which were conceived to set clear targets to drive performance improvements while offering a safety net against uncontrollable costs; but so far the well-intended approach has been lost in the voluminous mechanics of rate determination.
This year, we expect regulators to take a more realistic look at costs and cross-subsidies and revise tariff levels and refine tariff design to cover at least some of the gap and improve open access conditions to bring in more competition in supply. It will also help if regulators act collectively, such as through the Forum of Regulators, to harmonise both multi-year tariff design and open access regulations.
The operational efficiency improvements in most states too have failed to keep date with targets set, though the input-based franchisee has now demonstrated its viability as a key means for distribution reforms and to bring in private participation. It permits the hard-to-resolve issues, ie, transfer of assets, human resources, and investment rights to be kept status quo while permitting infusion of management and growth capital to be brought in by the private operators.
The outcomes of the recent distribution franchisees bids have come in a narrow band, suggesting that the state utilities are taking a conservative approach and the bidders are responding accordingly. In 2011 we expect to see that reserve melt and could see distribution franchisees of larger sizes being tendered by state utilities, offering a more balanced risk sharing, and presenting more confident data rooms with better quality data and this could help improve valuations for utilities and benefit the consumers. Given the large size of the distribution opportunity, we expect to see a large number of new non-traditional entrants as in the recent Nagpur and Aurangabad DF bids, although it is disappointing that other than Torrent, none of the larger power companies have taken any material steps to develop presence in this segment. We also expect to see more robust application of strategies and technologies such as the use of smart meters, ICT targeting tools, and management practices like shared services, multi-tasking, and outsourcing.
Generation: Securing primary energy sources
The upcoming generation projects will continue to grapple in the year with challenges in availability of equipment and technicians, land and environmental approvals, and coal supply. The domestic supply constraints are likely to double the quantum of coal imports over the previous year and considering that a significant proportion is still purchased through traders, can potentially spur up spot prices. The asset prices are also likely to move up even as the industry suffers a less salubrious investment climate with many forms of resource nationalism, ie, higher taxes, local supply obligation, ownership restrictions, etc.
Notwithstanding this, we expect larger power developers to continue with acquisition of thermal coal assets overseas, and in fact the scramble with multiple Indian bidders in the fray is likely to further buck up valuations. We also expect to see coal aggregators formally signing coal supply contracts with the smaller power developers and provide top-up products.
The development of captive coal blocks could have provided some respite to the industry, but only a handful of the 94 blocks allotted to power end-users have commenced production, with a combined output of about 35 million tonne, representing about eight per cent of total coal supply. The slow start has many localised reasons but an equally plausible reason is the inadequate management attention and the tendency of the awardees to engage in exploring options to leverage their allotment. In this year, we expect many state-owned utilities and mining companies to recover lost time and tendering to appoint mine developer and operators (MDO) through the PPP route.
Financing: The scope for FDI
The sector is expected to require a capital investment of over $400 billion over 2012-17 to meet the 100 GW target and related network development and it is expected that about 2/3rd of this will come from the private sector. Financing will be a challenge, considering that the sector's overall finances are still in the red, and the regulatory approach still falling short in providing a consistent and viable framework that can give confidence to investors. The available financing options and payment security is depleting fast and the flow of finance may come to a gradual halt unless markets can see internal cash surpluses of the state utilities coming into play.
The commercial bank lending, which has long been the mainstay to the sector, has seen lending go up from six per cent of outstanding (2000) to 12 per cent (2010), but with group and sector limits this may slow down and going forward reflect deposit growth. The sector lending institutions such as PFC, REC and other infrastructure lenders have significantly stepped up activity with disbursements increasing three to four times in this plan, but what growth strategies will be adopted as their cost of funds comes closer to the market is to be seen.
A number of central state-owned and private power companies and intermediaries have raised funds from the primary markets, and the power sector's share has gone up from 1.9 per cent of total funds raised (1994-99) to 10.5 per cent (2004-09). This year we expect to see state-level power utilities starting with a low-risk STU or an integrated captive coal power plant take steps towards an IPO.
The past year has also seen private equity make a strong come back at conventional power, boosting up the share of the power sector to 13 per cent of all investments.
Given the continued attractiveness and new entry in the sector, and broader global liquidity and capital market conditions, it is expected that PE activity will remain strong. In contrast, foreign direct investment (FDI) in the power sector has remained well below expectations, with a share of barely 7.6 per cent of all FDI, and might turn up at the gates this year.
Trading: Growing in confidence to save cost and carbon
The year has seen positive moves in power trading, with strong growth in volumes even as the market clearing prices have remained modest. The last two years have seen significant addition of private sector generation capacity, and the sale of surplus power by metal companies then hit by low demand has helped meet power demand as well as improve asset utilisation.
This represents a strong case for power trading as a more efficient means than long-term contracting. Going forward, the increase in merchant power capacity from 1,670 MW to over 5,000 MW in the year ahead will reflect in some measure on power trading as well, although the bulk will be already contracted.
The quantum of power trading as proportion of all power generated has now increased to 8.5 per cent (FY 10) and likely to close the year at 10.5 per cent (FY 11). The ratio of bilateral trade to UI to power exchanges is likely to improve to 50:35:15 this year. The market is still dominated by six licensees that constitute about 90 per cent of the total trade by all the licensees, but this will gradually change as new entries bring in their own capacity that can be traded more competitively.
Renewable Energy: Need a green highway without today's potholes
The renewable energy (RE) sector saw its most visible action under the National Solar Mission (NSM), with the bid process attracting strong participation and competitive tariffs.
The interest bodes well for the industry which is today about 17,000 MW (grid-connected) but still has a long way to go to reach 120,000 MW (by 2021-22, to meet the 10 per cent energy target). Investment flow in the current year, however, was towards wind energy projects and a number of green IPPs have raised capital to invest into new ventures.
The prospect of RECs, CERC regulations on inter-state sales and the widening scope of RPOs, is attracting new investment into the RE sector. This year we expect to see coming together of hybrid applications of renewable technologies such as CSP plants as a booster for feed-water heating in thermal power plants, as a means of saving use and transportation of coal especially where long distances are involved, and as coal costs increase over time.
A number of challenges remain. The market itself is somewhat elusive as despite states notifying RPOs, without penalties the targets remain merely good intentions. The mandatory RPO under NSM and penalties imposed in a few states is a step ahead in creating the renewable market. The problems of a market fragmented by different state regulations and motivations may become less worrisome as green trading picks up.
The two remaining challenges are to address tax reforms so that green power producers are not disadvantaged against financial investors and to liberalise open access for RE so that they can offer consumers access to green energy and low-inflation tariffs.
The authors are with PricewaterhouseCoopers. Rao is Executive Director (Energy, Utilities and Mining) and Raizada is Manager (Energy, Utilities and Mining). They can be reached at email@example.com and firstname.lastname@example.org respectively.