According to India Ratings and Research (Ind-Ra), regulated thermal power plants with long-term power purchase agreements (PPAs) will face heightened risk of PPA renegotiation. The agency does not envisage one-sided cancellation of PPAs as it would equate to contractual breaches, and hence considers this as a low probability event. The increased risk of PPA renegotiation, in Ind-Ra's opinion, would primarily be driven by a pressure on the distribution companies (discoms) to lower their power purchase costs to reduce the overall losses. MoUs signed by the discoms under Ujwal DISCOM Assurance Yojana envisage a reduction in per unit power purchase costs through a combination of efficient power procurement, and lower aggregate technical and commercial losses. As Ind-Ra envisages a limited possibility of tariff hikes due to push-back from consumers and the emergence of other renewable energy sources at competitive rates, the discoms would seek to reduce power purchase costs through renegotiation of PPAs.
Increase in per unit costs: The power sector in India has two types of tariff structures: single-part tariff and two-part tariff. The discoms are more comfortable with single-part tariff structures, as applicable in the power purchases made through power exchanges, bilateral contracts and short-to-medium term contracts for incremental power needs. The two-part tariff structure with fixed and variable components was more prevalent when the country needed a pick-up in capacity addition, and hence guaranteed the developers a fixed return on their investment provided certain operating benchmarks were met. It was easy to meet these benchmarks when the demand for power was higher than supply and coal availability was not an issue. However, once capacity was added in large numbers and demand growth was lower than expected, the plant load factor (PLF) took a hit (Figure 2). In such a situation, the discoms paid fixed costs even when the PLFs were low, thus increasing the fixed cost per unit and the overall power purchase cost (Figure 3). The discoms stopped signing fresh two-part tariff long-term PPAs after realising that low PLFs could translate into higher power purchase cost per unit.
The PLF in India is likely to remain low given the significant capacity addition with lower than expected demand growth. Thus, in an unlikely scenario of discoms moving towards cancelling high cost PPAs, there is a greater possibility of discoms seeking to lower annual fixed cost through renegotiation and recalibration of PPAs.
Modes of PPA Renegotiation: Ind-Ra opines PPA renegotiation for regulated thermal power plants could be indirect. The renegotiation could be done with a combination of the following factors: (i) change in Central Electricity Regulatory Commission (CERC) and state's regulations directed towards lowering the tariffs; (ii) equitable distribution of the fixed charges across off-takers through pooling of fixed costs for all the plants of a particular entity; and (iii) non-extension of PPAs signed for a duration of 10-15 years on completion of the initial contractual period.
Change in Regulations: The change in CERC regulations over the next control period (FY20-FY24) could target the following areas to allow lower tariffs: (i) elongation of amortisation schedule of term loans from the present 12 years; (ii) lowering of equity returns as highlighted by Ind-Ra in its wire, Risks in Regulated Thermal Power Plants - Lower Regulated Return on Equity; (iii) tightening of working capital norms and lowering of interest cost allowed on working capital; and (iv) increasing the normative debt/equity ratio as the cost of debt is lower than the cost of equity.
The current CERC regulations allow for loan amortisation over 12 years, leaving a long project tail life of 13 years with no loan amortisation. This leads to higher tariffs in the initial years compared with the latter years. If the loan tenures were to be more aligned with the actual project life, the same could result in lower tariffs. Also, the current regulations allow for normative debt-equity ratio of 70:30 with return on equity allowed of 15.5% and borrowing cost at the actual interest cost being paid on the loans, which can range from 8%-10%. If the debt-equity ratio was to be revised upwards to 80:20, the component of equity would decline, and the consequent absolute level of returns on it, aiding lowering of the tariffs. If the regulators were to take this stance, the tariffs would decline, thereby impacting revenue and profitability of the regulated entities. However, the ability of the banking system of accepting higher debt-equity ratio, extending long-tenure loans and thereafter pricing it competitively could pose a challenge. The state regulatory commissions usually follow CERC guidelines; thus, similar regulations can be expected in states.
Fixed Cost Pooling: The regulated entities have set up power plants over a period of time. Therefore, there are variations in their vintage and capital cost, leading to a significant difference in the fixed cost per unit. However, if the fixed costs for all the plants were to be pooled for a given entity, the fixed cost differences can be reduced. This measure, if adopted, would not directly impact the entities operating the plant but would have an impact on the discoms. As depicted in the table below, fixed cost per unit on a pooling basis is INR0.96/kwh, while on an individual plant level basis could vary from INR0.54/kwh-INR1.34/kwh.
Non-extension of PPAs: Some plants with PPAs of 10-15 years have an extension clause for another 10-15 years instead of a single duration of 25 years. Therefore, the off-takers may decide not to extend PPAs after expiry of the initial contract period if the fixed and variable costs are high. If the plant is unable to extend the PPA due to its high cost, its ability to enter into a fresh PPA with another counterparty at those high tariffs would be limited due to current power supply scenario in India and the emergence of renewable power at much lower tariffs. Although NTPC Limited ('IND AAA'/Stable/'IND A1+') has long-term PPAs for most of its plants with an initial contractual duration of 25 years, not all regulated power plants would have PPAs for a similar duration, leading to a risk of extension.
Ind-Ra, in a five-part series, will present its analysis on the changes in the business risk faced by regulated thermal power plants that operate under the cost plus return on equity model, which typically lends itself to higher cash flow stability and predictability. In Ind-Ra's opinion, those five risks are broadly classified as (i) lower regulated return on equity; (ii) lower fuel availability; (iii) higher contractual risk; (iv) lower competitive positioning; and (v) lower financial flexibility.
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