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Cover Story | December 2016

Light at the end of tunnel

With the advent of structural reforms, debt stress in power companies is expected to ease. However, their implementation is critical.
The Power Sector has the lion´s share of 20 per cent in the industrial debt of Rs.26 trillion (lakh crore) in the country as of August 2016, followed by metals and metal products (16 per cent), roads (7 per cent) and textiles (7 per cent), and these four sectors account for about 50 per cent of the gross credit deployed in industries. The Power Sector accounts for the largest share of 70 per cent of even infrastructure finance companies (IFCs), taking the total funding by banks and IFCs to Rs. 10 trillion as of August 2016.

The exposure to the sector ´has grown at a compounded annual growth rate of (CAGR) of 17 per cent over the last five years, higher than the banks´ overall credit growth to industries at 11 per cent CAGR,´ said rating agency ICRA, in a report recently. Thus, the credit quality of the power sector has a strong bearing on the asset quality of the financial sector as a whole.

Till last year, the power sector was in the midst of deep stress for a variety of reasons, including slowdown in signing of fresh power purchase agreements (PPAs) and coal supply woes. In mid-2015, rating agency CRISIL had said that a third of coal-based power generation capacities added between April 1, 2009, and March 31, 2016, tantamount to 36,000 mw, were facing viability risks. Besides, another 10,000 mw of gas-based capacities was facing viability risk for want of gas supplies. On the other hand, the power distribution companies (discoms) were to face severe liquidity pressure on expiry of the moratorium under the Financial Restructuring Package (FRP) announced in fiscal 2013, with no performance improvement in sight.

The government has in right earnest stepped in with several measures, including the launch of Ujwal Discom Assurance Yojana (UDAY) in November 2015, and expedited environmental clearances and land acquisition in a bid to boost coal supplies. In addition, the launch of 5:25 refinancing scheme also helped generation capacities facing viability risks. These measures are expected to improve the credit quality of the discoms over the next few years.

Discoms
Discoms are the weakest link in India´s power sector. The low capacity utilisation of the power sector is driven primarily by financially stressed power discoms, which are unable to purchase electricity due to their weak financials. ´It is a combination of crippling debt built over last few years, aggregate technical and commercial (AT&C) losses, less-than-commensurate increase in tariff, and dearer power over the last few years which have resulted in discoms saddled with huge accumulated losses (end-March 2015: Rs.3.8 lakh crore) and towering debt (end-September 2015: Rs.4.3 lakh crore),´ said Rachna Jain, Associate Director - Corporate Ratings at Fitch Ratings. Most of the financial exposure to the sector is towards discom/generation. In addition to these, the industry has had to bear several additional challenges including ´change in mining regulations by Indonesia and Australia on coal exports, pushing-up the cost of imported coal for Indian entities without a matching increase in tariffs. Apart from exogenous factors, aggressive bidding without covering for input cost risk and foreign currency risk, have also proved to be the nemesis of several IPPs,´ said Anjan Ghosh, Chief Rating Officer, ICRA.

UDAY
The Centre has introduced a voluntary rehabilitation scheme, Ujwal Discom Assurance Yojana (UDAY), for financial and operational turnaround of distressed state discoms. The four-pronged strategy of the comprehensive scheme aims at reducing the interest burden, improving the operational efficiency, reducing power purchase cost and enforcing financial discipline in discoms. This has raised a lot of hopes on the future health of discoms and eventually, of the Power Sector as a whole.

Reflecting a wider acceptance, 17 states, including one union territory, have adopted the financial restructuring scheme, while four more have accorded an in-principle approval to the scheme. As of August 2016, bonds worth Rs.1.7 trillion have also been issued by the participating states.

´We expect the actual direct exposure to State Electricity Boards (SEBs or discoms) to come down significantly for banks due to UDAY package, which converts 75 per cent of the debt into state-government bonds. The remaining direct exposure is expected to be held in the form of loans or bonds. However, intuitively, I would expect any exposure to SEBs to be treated as stressed unless one is able to see tangible improvement in their performance,´ says Saswata Guha, Director - Financial Institutions, Fitch Ratings.

UDAY is expected to improve the health of the state discoms over the next three years, which, in turn, will benefit power generation and transmission companies via timely clearance of dues and higher utilisation levels, and new projects with signing of power purchase agreements (PPAs). ´However, timely reduction of AT&C losses and adequate tariff hikes are essential for a sustainable improvement of the state discoms,´ says Jain.

´We expect average all-India thermal PLF levels to show some improvement from 59 per cent in August FY2017 to a range of 61-63 per cent in the near term; although still at subdued levels. This will be driven by off-take from the discoms,´ Sabyasachi Majumdar, Senior Vice President, ICRA Ratings, said.

CRISIL forecasts that the discom losses in the UDAY states will reduce the gap, but not close the gap fully as envisaged by the scheme, from 64 paise in 2016.

´The gap will reduce to 28 paise due to lower-than-expected reduction in AT&C losses and tariff hikes,´ the rating agency said.
´Aggregate discom losses for the 15 states (later 2 more states joined) remained high at Rs.37,000 crore in fiscal 2016 largely because of high AT&C losses of 23 per cent. With the implementation of UDAY, this is seen declining to Rs.21,000 crore, and AT&C losses to 18 per cent, by fiscal 2019,´ says CRISIL.
CRISIL has identified that Rajasthan, Haryana, Andhra Pradesh, Punjab, Chhattisgarh, Karnataka and Madhya Pradesh to will see maximum improvement in financial risk profiles and will be the key beneficiaries of UDAY. While UP, Bihar, and Jammu & Kashmir, will also show considerable improvement, these will continue to remain confined to the weakest quadrant due to lower-than-envisaged improvement in AT&C losses and resultant gap per unit.

Tariff under-recovery
Inadequacy of tariff revisions by state electricity regulatory commissions remains a major concern, even after introduction of UDAY. ´The magnitude of improvement in discom efficiency (read reduction in AT&C losses) in line with the stipulated targets as well as the timeliness and adequacy of tariff hikes in relation to the increase in cost of power supply remain critical for the long-run improvement in the financial position of discoms,´ said Ghosh. The tariff orders issued recently by the utilities in Punjab, Uttar Pradesh and Rajasthan have not only come with delays, but the actual tariff revisions have also been lower than the level stipulated under the MoUs signed for implementation of the UDAY Scheme. ´This implies that unless the ever-present political compulsions -avoiding or minimizing tariff hikes- remain rooted, achieving a sustainable turnaround in the financial and operational position of state-owned discoms would remain difficult. Till then, the ´discom weak link´ would remain an overhang on the overall credit quality of participants in the power sector supply chain,´ Ghosh said. This may also curb investor appetite for infusing capital in the relatively nascent but fast growing renewable energy sector, increasing risk premiums and thereby the cost of capital.

However, describing the power prices as a soft spot, Fitch Ratings said, ´We expect electricity prices to continue to hover at their low levels in 2017. This will be driven by high generation sent out from power stations, continued grid congestion and poor financial health of discoms limiting off-take.´

Imported-coal based plants are facing another problem - fuel price risk. These projects were bid quite aggressively with no scaleable fuel charge component at a time when the price of coal imported from Indonesia was low. But later, when the Indonesian government changed the rules, imports became costly. This significantly dented the cash flows of these projects. The parleys with the government are on seeking compensatory tariff for cost under-recovery.

PPAs
Fresh PPA signings unlikely till discoms turn profitable, affecting generation companies (gencos). Given continued losses on every unit of power sold, the energy requirement projected by discoms remains constrained, leading to fewer PPAs being announced. That´s why, despite significant power cuts across the country, most discoms are projecting a power-surplus situation and their energy requirements have grown at a compounded annual growth rate (CAGR) of 3.7 per cent in the three fiscals to March 31, 2016.

´After UDAY, with the financial health of discoms improving, village electrification increasing, and losses reducing, the energy requirement of discoms is expected to grow at a CAGR of 7 per cent till fiscal 2019. But given their continued losses, the energy requirement of discoms will be much lower than what would be needed to meet the Narendra Modi government´s ´Power for all´ objective,´ said CRISIL in a report.

Due to constrained energy requirement of discoms, capacities without PPAs continue to increase. CRISIL estimates that nearly 17 per cent of already-commissioned private sector capacities are without PPAs. The rate of increase in private-sector capacity far outpaces PPA signings by states.

Generation
CRISIL estimates aggregate debt to weak gencos, both thermal and gas-based, stood at Rs.1.7 lakh crore as on March 31, 2016. Of this, 45 per cent, or Rs.76,000 crore, of debt could benefit from structuring under various tools provided by the Reserve Bank of India (RBI) to banks to support viable projects. Another 15 per cent, or Rs.24,000 crore of debt, has the backing of strong sponsors. Net to net, Rs.70,000 crore of debt to weak gencos, which were operational as on March 2016, is at risk. Another 26 projects under construction, with a capacity of about 24,000 MW, are also weak. Their debt outstanding is Rs.64,000 crore and this is also at risk. Thus the total genco debt at risk over the medium term is Rs.1.34 lakh crore. The stressed credit profile of power sector borrowers, mostly the private sector IPPs, reflects in the deteriorating asset quality indicators of banks and IFCs, pertaining to their exposure to the power sector.

´The cumulative Gross Non-Performing Assets (NPAs) and restructured advances as a proportion of gross advances of three large financial institutions (FIs) collectively account for over 50 per cent of the total credit extended to the power sector, are estimated to have increased to 12 per cent as of June 2016 from 8 per cent as of Mar 2015,´ said Ghosh of ICRA.

With a slew of measures such as improving coal availability and 5:25 refinancing, we now assess operational thermal capacities at risk have reduced to 40,000 MW from 46,000 MW of coal- and gas-based capacities commissioned between April 2009 to March 2016, which were facing viability risks due to lack of PPAs, inadequate fuel supply, and aggressive bidding both for projects and coal blocks, according to CRISIL. Availability of coal has improved in the last two years due to sharper focus on stepping up production, led by faster environmental clearances and land acquisitions. This increase in coal availability has resulted in increasing the comfort level of some generating companies over the last one year.

CRISIL feels that with more and more state discoms signing up for UDAY, bank/ financial institution debt to discoms is expected to decline significantly over the medium term, thereby reducing the pressure on financiers.

Transmission
Though not many players are involved in the national transmission network building at present, private participation is expected to see a leg up in the next few years. Fitch expects greater private-sector participation in grid assets as more projects are tendered, although PGCIL will account for more than two-thirds of new capacity investments.

Fitch expects rated companies - PGCIL, Adani Transmission Limited and NTPC - to bid prudently for new projects under competitive bidding. Interest and investments in renewable energy will continue, supported by government policy initiatives. However, bidding discipline - especially in solar - remains an issue.

Delinquencies
NPAs in the power sector have increased sharply to 5.7 per cent of total loans by March 31, 2016, from 1.6 per cent a year ago.
This was driven by NPAs accrued via gencos over the past year.
The proportion of restructured standard assets (RSAs) in the power sector also remains high at 20 per cent of total RSAs outstanding in the banking sector as on March 31, 2016. This is despite almost Rs.75,000 crore of restructured loans to discoms getting converted to state government bonds in fiscal 2016 under UDAY, said CRISIL. ´Overall loans to the power sector that are under distress (NPAs + RSAs) was high at 16.4 per cent by March 31, 2016, but lower than the 19.3 per cent seen at the end of fiscal 2015.
The reduction is on account of conversion of some discom exposure to state bonds under UDAY,´ CRISIL added in a report.
CRISIL also believes lending to the power sector will grow at slower pace than in the past, at a CAGR of 10 per cent during fiscals 2017 to 2019, and touch `15.5 lakh crore compared with 20 per cent CAGR seen during fiscals 2012 to 2016. Incremental lending will be across generation, transmission and renewables sectors, with only a marginal increase in exposure to discoms.

Looking ahead Distribution Companies´ efficiency is the key to better financial profiles of all players in the sector. Policy actions taken so far would prevent further deterioration in credit quality in the power sector. However, improvement will depend on the pace of implementation of reforms, meeting set targets, improving the efficiency of discoms, thus, increasing the demand for power by removing artificial barriers, ensuring fuel supplies etc.

With implementation of reforms meticulously, particularly UDAY, the loan burden is expected to shift to states from discoms in the medium term, strengthening the health of the latter and boosting the activity in the whole sector. This will address asset quality challenges across the sector.

Ensuring fuel supplies to even companies where PPAs are not signed will improve their viability, otherwise credit risk is set to touch the roof because of idling of built capacities.

CRISIL has identified three states UP, Bihar, Jammu & Kashmir as the laggards in meeting key parameters under UDAY.

So, the government´s focus should be centred on improving operational efficiencies of discoms in these states. Above all the government should make sure that compensatory tariffs are adopted in all states that are signatories to UDAY.

Ultimately, a failure to rehabilitate discoms would be negative for the whole power sector, as it will increase the receivable days for power generators and transmitters affecting their cash flows and financial profiles negatively.

In that context, wherever necessary private participation in discom operations should be encouraged.

- BS Srinivasalu Reddy

Factors that will drive future ratings: ICRA

Factors that may support ratings

Demand recovery from high paying consumer segments:
If energy demand from the industrial and the commercial sector gathers momentum, it would be a positive for discoms as it is this segment that pays higher tariffs and cross-subsidizes tariffs in the household sector. It would also support the PLFs and profitability of power producers, specifically for those that do not have to contend with tariff under-recoveries or face legacy compensatory tariff issues.


Reduced costs:
Operating costs of IPPs are expected to reduce by virtue of steps taken by the government towards rationalization of coal linkages, coal swapping from inefficient to efficient plants and coal price rationalization based on gross calorific value.


Foreign investments:
Lately, India´s power sector has seen growing interest from foreign investors, both financial as well as strategic. This augurs well both from the standpoint of funding risk as well as management risk associated with such projects. Still, there is reason to remain cautious as default on debt servicing by any of these projects in the wake of delayed receipts from discoms could turn investor sentiment for the worse.

Factors that may not constrain ratings any more

Coal availability:
The concern related to insufficient domestic coal availability stands largely addressed following pump up in coal production by Coal India Limited, so much so that IPPs are no longer facing loss of generation because of coal supply shortage.

E-auctions: Following the launch of DEEP (Discovery of Efficient Electricity Price) by the government, it is now compulsory for state discoms to purchase short-term power through reverse e-auctions. This initiative is expected to bring in greater transparency and lead to a reduction in power purchase costs for discoms.

Growing transmission capacity: Large investments have been made and sizeable fresh projects have been awarded to enhance transmission capacity. This should gradually mitigate evacuation concerns of IPPs.

Factors that continue to pose credit concerns
Discom health:
The UDAY scheme, for now, has provided the much needed short term fillip to discoms that would reduce their interest expenses bill. Further, initiatives such as DEEP as well as deployment of energy efficient solutions, compulsory smart metering and upgradation of transformers should improve the overall operational efficiency of discoms. Yet, discoms would remain the Achilles´ heel for the power sector till such time as tariff fixation remains detached from power supply costs as also AT&C losses remain sub-optimal. Also, with commercial banks not providing loans for loss funding, liquidity could come under stress till such time that there is sustained improvement in operating efficiency.

Gas availability and pricing: Gas based projects with aggregate capacity of over 20,000 MW continue to remain idle for want of gas at competitive prices. Likewise, several IPPs may face viability risk for having bid aggressively in coal auctions.

Industry consolidation and inorganic growth: At a time when a large number of IPPs are saddled with heavy debt and are facing profitability and liquidity problems, asset sales and industry consolidation trends are taking shape. While this may end-up being a credit positive for the sector as a whole over the longer-run, it remains fraught with the usual risks associated with inorganic pursuits including, expensive valuations, integration challenges and so on. These factors may weigh on the acquiring entities´ ratings.

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