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Power tariff policy 2006: Our view - Views on News from Equitymaster
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Power tariff policy 2006: Our view
Feb 7, 2006

The Ministry of Power has reiterated its ‘Electricity to all’ goal of adding 100,000 MW of power capacity during the 10th and 11th five year plans, in order to have per capita availability of 1,000 units of electricity per year (from the current levels of 661 units) and eliminate energy and peaking shortages. Towards this, the ministry has stressed on attracting adequate investments (read private sector investments) in the power sector by providing ‘adequate’ return on investment to the participants. Key objectives of the policy

The key objectives of the tariff policy include:

  1. Ensuring availability of electricity to consumers at reasonable and competitive rates,

  2. Ensuring financial viability of the sector and attract investments,

  3. Promoting transparency, consistency and predictability in regulatory approaches across jurisdictions and minimise perceptions of regulatory risks, and

  4. Promoting competition, efficiency in operations and improvement in quality of supply.

Implications of the policy
The latest policy guidelines are likely to benefit public sector power utilities. The following excerpt from the policy paper shall make this clear.

“All future requirement of power should be procured competitively by distribution licensees except in cases of expansion of existing projects or where there is a State controlled/owned company as an identified developer and where regulators will need to resort to tariff determination based on norms provided that expansion of generating capacity by private developers for this purpose would be restricted to one time addition of not more than 50% of the existing capacity.

Even for the Public Sector projects, tariff of all new generation and transmission projects should be decided on the basis of competitive bidding after a period of five years or when the Regulatory Commission is satisfied that the situation is ripe to introduce such competition.”

Now, while the government has called for competitive pricing for obtaining power by the private sector distribution players, the ‘state-controlled or owned company’ has been exempt from the same. This is to say that the cost of power that the public sector distribution companies obtain from generators ‘will’ continue to be decided by the regulator. Even the generation and transmission projects of public sector utilities will face competitive bidding only after a period of five years. There are no such relaxations for private sector players in any of the three segments of generation, transmission and distribution. Also, private sector generating companies would be restricted to one time capacity addition of not more than 50% of their existing capacities. These factors, we believe, will effectively act as an artificial suppression of effective competition in the industry, which is ironically one of the objectives laid down by the policy.

Equity norm
The policy states that the return on investments in the sector should be such so as to attract higher investments from both public and private sector players. This is intended towards rapidly scaling up the generation capacity in the count, which has been lagging the planned pace of addition over the past many years. Apart from attracting new investments, the rate of return should be such that it allows generation of reasonable surplus for long-term sustainable growth of the sector.

The policy reiterates that financing of future capital cost of projects shall require a debt to equity ratio of 70:30 (Example: Rs 1,000 m project shall be funded through Rs 700 m of debt and Rs 300 m of equity, the latter including internal accruals). Now, while promoters can have a higher quantum of equity investments, the equity in excess of the 70:30 norm should be treated as loans advanced at the weighted average rate of interest. On the contrary, in case of equity being below the 30% level, the actual equity would be used for determination of Return on Equity in tariff computation.

Return on Equity
  Past Present Future probability
Equity component 50.0% 30.0% 30.0% 30.0% 30.0% 30.0%
Cost of equity 16.0% 14.0% 13.0% 12.0% 11.0% 10.0%
Cost of debt 6.0% 6.0% 6.0% 6.0% 6.0% 6.0%
Return on investment 11.0% 8.4% 8.1% 7.8% 7.5% 7.2%

The above table indicates the fact that the risk of the assured return on equity being further lowered has been minimised, with the regulator reducing the equity component from 50% of total investment earlier to 30% currently. This is considering the fact that the weighted average return on investment has already declined from 11% (when equity component was 50%, cost of equity was 16% and cost of debt was 8%) to 8.4% (equity component being 30%, cost of equity being reduced to 14% and cost of debt remaining at 8%). Now, even if the return on equity were to drop to 10% (highly improbable considering the need to attract higher investments to the sector), the weighted average return on investment will decline by just 1.2% to 7.2%. We believe that a reduction, if any, will have almost negligible impact on electricity tariffs.

Issue of cross-subsidy
The government seems to be realising the essence of ‘rational and economic pricing’ of power. This is seen by the guideline that there has been an indication towards direct and effective targeting of electricity subsidy to the needy population. In order to achieve this objective, the policy guidelines lay down that the “state electricity regulatory commissions (SERCs) would notify roadmap within six months with a target that latest by the end of 2010-11, tariffs are within ±20% of the average cost of supply.” As an example, is the average cost of electricity is Rs 3 per unit, tariff for the cross-subsidised category (read, the poor/rural strata) should not be lower than Rs 2.4 per unit (Rs 3 minus 20%) and that for the cross-subsidising category (basically industries) should not go beyond Rs 3.6 per unit (Rs 3 plus 20%). We believe that a well-defined cross-subsidy mechanism will not only discourage wasteful consumption of electricity but also reduce strain on the distribution network that can, consequently, improve the quality of power supplied.

While the tariff policy aims at ensuring financial viability of the power sector and consequently attract the required funds for expansion purposes, it seems to have left a bitter pill to chew for private sector players by way of clauses with respect to competitive bidding. Also, while the policy has ‘drafted’ a course of action for the participants, the beginning of the process of ‘implementation’ still seems long away.

Investments in power stocks would thus have to be with utmost caution. Investors should understand the ‘long gestation’ nature of the sector and not expect returns in the short to medium term. NTPC remains our preferred play from the sector.

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