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Cover Story | October 2017

Strategists look for scale & operational optimisation in M&A

<span style="font-weight: bold;">Manish Aggarwal, Partner, Head- Corporate Finance - M&amp;A, Debt Advisory -Infrastructure, Head - Energy and Natural Resources, KPMG in India <br /> <br /> What is the kind of interest in buying these stranded capacities and what strategic abilities buyer should have to bring them back into operation?</span><br /> Strategic investors derive value by bringing in much valued technical and implementation capability. Strategists are more interested in a portfolio which gives them necessary scale and possible operational optimisation that can help them drive returns. There is limited interest for under-construction assets. Acquiring projects that are already in operation is a less risky way to enter the market than constructing a long gestation period asset. <p></p> <p>As against strategists, I believe bulk of mergers and acquisitions (M&amp;A) in short to medium term would be driven by financial investors. Assets which have their linkages sorted (e.g. PPA and fuel supply agreements or FSA) and that can be turnaround with financial engineering are the primary targets of financial investors. Investors are also looking for a bolt on strategy by acquiring a relatively simple and small asset in the beginning to understand the ground reality and gain confidence around assimilating the change before acquiring larger and more complicated portfolios. Also, I believe all this activity will further be restricted to the operating assets only. </p> <p> <span style="font-weight: bold;">How lower plant load factor (PLF) will affect the viability of the existing private power plants in operation?</span><br /> There has been a free fall in PLF's of thermal power stations in past 18 months. Plant load factor at coal-fired have reached ~ 60% in the first half of 2017. Increased capacity addition from renewable sources and lack of demand from Discoms are major contributors to that. The curtailment in demand from Discoms is mostly driven from financial considerations rather than fundamentals. With improvement in financial health of Discoms we expect some improvement from the current levels of PLF. </p> <p>However, it's unlikely to achieve the levels that we have seen in past. Most of the incremental demand is likely to be met from increased supply from renewable sources, hence, I don't foresee any substantial improvement in PLFs in near term. At the same time, I believe that if the economic growth and underlying industrial demand picks up and this when seen with the fact that there is no new supply is envisaged for some time, and renewables going through their own challenges, select operating assets when bought over with right sized capital structure will stand high probability of running at high PLFs over medium term.</p> <p> <span style="font-weight: bold;">In what way the falling renewable energy prices will impact TPP profitability and ultimately, their viability? How feasible Rs 3/kWh is for TPPs?</span><br /> I personally don't foresee renewable as a competition to conventional projects. This is a way in India we have created the narrative since our old fascination of 'one fuel at a time' syndrome. The way I look at base scenario is that of cooperation rather than competition. There is no disagreement on the fact that coal is a ;dirty fuel; and in order to overcome climate change, the government must exponentially increase generation from renewable sources. There is also no denying the fact that incremental capacity addition will largely be through renewables. </p> <p>But at the same time, we need to understand that renewable cannot replace conventional as a bulwark of energy system. The change will happen, but it will take time. India's massive power grid system needs re-balancing to deal with the fluctuating/erratic nature of power generated from renewable energy flowing into the system and keep supply in sync with demand. Increased share of renewables would require enhanced investments in transmission or peaker plants. There are costs attached to it. Conventional and renewable cater to different load profiles. So, pegging a conventional tariff based on trends in renewable tariff discovery won't be appropriate. Conventional would command a definite premium because of their on demand nature of generation.</p> <p>Having said that, it's a reality that current tariffs seen in renewable auctions does put utilities in a bind from commercial perspective to accept much higher tariffs for thermal IPPs. It is another debate that how sustainable these renewable tariffs are, and what's happening to projects that have bid for such tariffs recently, and why we are not seeing more auctions of late. Therefore, for short term, tariffs for thermal IPPs will be under pressure. I don't want to comment on a specific number, but I strongly feel that we are going through a transition at present and water will soon find its own level where both will co-exist, and must co-exist if India has to supply power to all and for ensuring energy security of the country. </p> <p> <span style="font-weight: bold;">What is the quantum of bank debt for power sector, and how it is set to pan out in the coming months/years? What is the admissible/usual debt-equity ratio for TPPs?</span><br /> We understand that total stressed assets on bank books have risen to about Rs 10 lakh crore. Apart from iron and steel, power is the largest contributor to stress for banks. Total loans to the power sector, including those to distribution and transmission firms, stand at Rs 5.24 lakh crore. These are broad estimates and may be dated.</p> <p>It's difficult to comment on usual debt-equity ratio as it depends upon specifics of the project such as project cash flows, security package etc., offered to lenders. The generic normative debt equity-ratio for financing conventional power projects is 70:30, however this can vary depending upon project specifics.</p> <p> <span style="font-weight: bold;">Is consolidation the remedy or are there any policy changes that may be of help in resolving the sector's debt woes?</span><br /> The major reasons for stress in the power sector are non-availability of regular fuel supply arrangements, lack of PPAs, promoters' equity crunch, and regulatory and contractual issues. The latter two essentially impact under-construction projects whereas the rest impact all projects. Consolidation in itself is not going to yield benefits without structural changes. Consolidation may help benefit on account of optimisation in financing and/or operating structure, but it's not going to yield result unless and until the core issue is sorted out. The reason for bulk of stress is structural and much beyond the control of consolidating parties to manage. </p> <p>Leaving aside under-construction projects which have a completely different risk profile, we can broadly put stressed operating projects in three buckets:<br /> 1.Projects with PPA but without FSA<br /> 2.Projects having Letter of Assurance (LoA) or FSA but not having a PPA<br /> 3.Projects without PPA/FSA<br /> <br /> I personally feel that government did not realise the intensity and gravity of the situation at start, and went on to focus only on renewable capacity addition without addressing some fundamental structural issues around large thermal capacity. Coal auctions added to these woes, and unhindered reverse auctions where single objective was to achieve further lower tariff, compounded the problems. The basic construct that low tariffs also have to be sustainable that offers reasonable returns to investors was missed. The fact that demand not picking up, and therefore to have measured capacity addition approach overall was missed as well. </p> <p>Of late, the Government has initiated some measures to alleviate stress in the generation segment. SHAKTI policy, which aims at removing fuel supply bottleneck shall help in reviving projects in the first bucket. The Government is formulating a centralised scheme to revive stressed power assets by inviting competitive bids to supply electricity for five years that will help projects in Buckets two and three to tide over temporary challenges till demand picks up. Innovative power procurement framework on the lines of capacity auction or peaker plants may be thought off to cater to large scale integration of renewables.</p> <p> <span style="font-weight: bold;">It is said, consolidation is in the air in thermal power generation segment. What are the signals that are pointing to this emerging trend?</span><br /> Depressed demand growth, lack of adequate power purchase agreements (PPAs) to tie-up the capacity along with mounting debt has forced players to a situation where they no longer can hold on to these assets. This has offered an interesting play around stressed assets especially when seen in the context of legislative and regulatory frameworks that have been put in place recently to deal with such assets from lenders' perspective. Assets with long term tie-ups and potential of turnaround with right sizing of capital structure are attractive candidates for special situation funds-/ infra funds. Large investors and conglomerates who had earlier stayed away due to skepticism are considering acquisitions of operating capacity as an attractive, low risk strategy to enter the market. Having said this, it will be a very selective asset play and to my mind large part of capacity will still not find a solution. </p> <p><span style="font-weight: bold;">A lot of power projects are awaiting PPAs. To what extent these projects are in a position to service their debt, if the wait is prolonged? How the low merchant power prices are impacting them?</span><br /> Around 16-20 GW of operational capacity lack long term PPA (broad estimates). Although individual ability to service debt largely depends upon the specific cost structure, however given current unsustainable merchant prices almost all such capacity is facing stress albeit with different levels of severity. Many such operating projects are also suffering from group level stress constraining promoter's ability to infuse liquidity in project to tide over temporary challenges.</p> <p>Given weak industrial activity base demand hasn't picked up. Merchant prices have also been impacted because of lack of interest of power distribution companies (Discoms) to off-take power beyond a certain price. The situation is likely to improve in medium term with pickup in demand and improvement in operating, and consequent financial condition of Discoms. In the interim, the proposed scheme of government coming up with centralized PPA's for certain capacity will help in tiding over immediate challenges. However given the quantum of stressed capacity more such structural initiatives are required. This links back to my response to first part that only selective capacity will find buyers, and large part of capacity still has no solution in sight.</p> <p> <span style="font-weight: bold;">What is the generation capacity, particularly of TPPs, that are weighed down by debt and is ready to be put on sale? </span><br /> Around 20 GW of operating capacity and 19 GW of under-construction capacity do not have a PPA are clearly stressed and available for sale. In addition there are projects with partial PPA's or PPA's at unviable tariff adding to overall stress in the system. In terms of quantum, around Rs 10 lakh crore of overall banking exposure is under stress with power being one of the major contributors. Again my personal view is that that around 50 to 60 GW of capacity is under some stress or other, and thus the banking system around debt will be huge. </p>
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