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Financial structure in the Indian power sector
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Energy Polio'. Vol. 23. No. 11. pp. 981-990. 1995 Copyright ;t'i 1995 Elsevier Science Ltd Printed in Greal Britain. All rights reserved 0301-4215/95 $10.00 + 0.00
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Financial structure in the Indian power sector Jamie Carstairs and David Ehrhardt London Economics Ltd, 66 Chiltern Street, London, WIM 1PR, UK
In India, the private power initiative of 1991 has offered one solution to the financing problem the private financing of generation against long-term power purchase agreements. However, this approach encounters a major problem, the financial weakness of the purchasing agents, the state electricity boards, that play a dominant role in most state's power sectors. At present the SEBs are mostly loss making; even the best performers realize returns on assets well below the cost of capital that they now face. The situation is likely to become worse as costs rise, further weakening the ability of the SEBs to sign credible long-term power purchase contracts. The private sector has responded by trying to reduce its exposure to SEBs through obtaining guarantees from state and central governments. There are a number of responses to this problem. The SEBs could try to become financially stronger through both cost reduction and increased revenues from higher tariffs and better collection. However, to make the SEBs and EDs into credible long-term power purchasers, power sector reform and regulation is needed. As these actions will take time, other responses could be investigated such as reducing the role of state power utilities by, for example, giving private generators direct access to industrial consumers. The long-term solution requires more profitable SEBs, if these bodies are to continue to play a dominant role in state-level electricity provision. Profitable SEBs will have access to finance from a range of domestic and international sources. The article finishes with consideration of the factors that will affect the optimal capital structure for SEBs. Kevwords: Electricity; Finance; India
The Indian power sector has an enormous financing requirement. Its rapid expansion over the last forty years has mainly been financed through grant and soft loans from the public sector in different forms. That source of finance is now drying up, forcing the sector to look for alternatives. The private power initiative since 1991 has offered one solution to the financing problem, through private financing of generation against long-term power purchase agreements. However, it has not yet addressed the fundamental problem, which is that state electricity boards (SEBs) are too financially weak to borrow from commercial sources and therefore also too weak to sign longterm contracts. The private sector has responded by trying to reduce its exposure to SEBs, in particular through state and centre guarantees. Despite a host of Memoranda of Understanding and a huge wave of interest in private financing, the basic con-
ditions for private financing have not yet been met. The key condition for private investment in generation to proceed is that there is a credible body to sign the contract. In all states that remains missing, and as a result the intention to shift power financing off the books of the public sector is still a long way from being met. In most states the SEB, or electricity department (ED), has a dominant role. The SEBs are large enterprises. Many have turnover of several hundred million dollars per year, and the largest have a turnover exceeding US$1 billion. At present they are mostly loss making. The best performers realize a positive return on assets, but at levels well below the cost of capital that they now face. The private power policy therefore faces a problem which it is still a long way from resolving. The intention is that state power utilities should contract for new generation, without recourse to public funds or guarantees. Energy PolicT 1995 Volume 23 Number 11
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Financial structule in the Indian power sector: J Carstairs and D Ehrhardt
Table I Shares of electricity consumption (%) First plan
Eighth plan
Industrial Agricultural Domestic Commercial Other
42.0 28.2 17.2 5.8 6.8
62.6 3.9 12.6 7.5 13.4
However, the utilities are mostly loss making, and likely to become more so as the costs of power purchase increase. They can reduce costs, through efficiency gains, and increase revenues through higher tariffs and better collection. These actions will take time. The financial weakness of the state utilities is likely to stall private power development for some years. There are two possible responses to this problem. The role of state power utilities could be reduced, through a variety of market mechanisms giving private generators direct access to industrial consumers. Alternatively, the SEBs and EDs could be transformed into suitable bodies to act as power purchasers. That means not just making them profitable, but setting in place long-term regulation that will keep them profitable provided they operate efficiently. The paper assumes that, in some states at least, the SEB or ED will continue to play a major role. The focus is on how to improve SEBs rather than on how to replace them. Given this assumption, the purpose of this paper is to consider what financial options are open to the state power utilities; to look at the kind of changes that would be required for them to access new financial sources; and to set out some preliminary thoughts on an optimal financial structure.
Financing requirement The power sector in India has grown rapidly over the last 40 years. The utilities installed capacity has increased from 1713 MW in 1950 to 7 6 7 1 8 M W by March 1994 and generation from 5100 GWh to 323 323 GWh. In addition to rapid population growth, per capita consumption has grown from 15 kWh in 1950 to over 270 kWh now.
This period of growth has also seen a shift in the nature of electricity consumption. The power sector has moved from being dominated by industrial sales to a larger share for residential and agricultural consumers (see Table 1). Although demand forecasts are made periodically (the 15th Power Survey representing the latest example), it is difficult to turn this into an investment requirement for a variety of reasons. First, the Indian power sector has become accustomed to severe financing restrictions. As a result, planning tends to focus on disbursement of 982
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Table 2 Additional capacity required Peripd Capacity requirement (MW) Eighth Plan Ninth Plan Tenth Plan
30 538 37 400~48 400 45 000-53 000
the funds available, rather than on total requirements. To use the jargon of the Indian power sector, there has been a bigger role for 'resource based planning' than for 'needs based planning'. This results in a planning process that disburses the funds available but shows a capacity gap in megawatts. Less attention has been given to preparing a forecast of total investment requirements to meet unconstrained demand, leading to a financing gap. There remains a high degree of coordination and centralization in the Indian power sector. The formal responsibility for preparing least cost expansion plans for the states lies with the Central Electricity Authority, the CEA. However, this role has not been undertaken very actively, again because of the rather academic nature of least cost expansion plans whose costs greatly exceed the sums available. A third element of the lack of a clear expansion plan has been the tendency to develop private power proposals on a negotiated rather than competed basis. The result is that proposed investments do not emerge from an overall planned expansion, and competition for identified projects. Rather they spring from a dialogue o~en initiated by project sponsors rather than the utilities themselves. It is, however, possible to make minimum estimates of magnitude of the investment requirement. Demand forecasting and investment planning in India tend to be structured around five-year planning periods. Table 2 shows the estimated requirements for additional capacity during the Eighth, Ninth and Tenth Plans. These run from 1992/93-1996/97, 1997/98-2001/02 and 2002/032006/07 respectively. It should be noted that the figure for the Eighth Plan period already represents a concession to the scale of funds available. The required capacity addition was originally estimated at over 35 000 MW, and was subsequently reduced in line with the level considered feasible. There is no accurate way of estimating the cost of these proposed investments. However, at least an approximate estimate is required to show the scale of the financing problem. We have assumed that these capacity additions will take the form of coal-fired plant, with unit size of 300 MW and a cost per megawatt of US$1.3 million (including FGD). This cost estimate is based on de-
Financial structure in the hldian power sector: J Cai:s'tairs and D Ehrhardt
Financial position
Table 3 State power bodies Department of electricity board Andhra Pradesh Arunachal Pradesh Assam Bihar Goa Gujarat Haryana Himachal Pradesh Jammu and Kashmir Kamataka Kerala Madhya Pradesh Maharashtra Manipur Meghalaya Mizoram Nagaland Orissa Punjab Rajasthan Sikkim Tamil Nadu Tripura Uttar Pradesh Bengal
APSEB ED ASEB BSEB ED GEB HSEB HPSEB PDD KEB KSEB MPEB MSEB ED MeSEB ED ED OSEB PSEB RSEB ED TNEB ED UPSEB WBSEB
Power corporation
Licensee
APGPC
BHPC, TVNL G PCL
AECO
KPC
TPC
OPGC
U PRVUN WBPDC
tailed cost estimates for investments currently under consideration. Using this simple rule of thumb, the annual investment requirements would be around US$7.9 billion during the Eighth Plan, US$9.7-12.6 billion during the Ninth Plan and US$11.7-13.8 billion during the Tenth Plan.
State power utilities SEBs play a key role in the Indian power sector. This section briefly summarizes the responsibility for power supply within different states. It then looks in greater detail at their overall financial performance, and at the legislation governing SEBs. India is made up of 25 states and 7 union territories. In all union territories except Delhi power is the responsibility of an electricity department, while in Delhi it is undertaken by DESU. Within the states the responsibility lies in most cases with the SEB (although a number of the smaller states operate through an electricity department). Though the states have their own generating facilities, they obtain a large share of their supplies from the NTPC. The Electricity Supply Act also allows for the creation of power corporations, which carry out generation and in some cases bulk supply to major consumers. There are also a few private companies that are licensed to operate in the power sector. Table 3 summarizes the state level bodies involved.
In most large states the SEBs have a monopoly of supply. Unless there is a substantial change in industry structure, they will continue to be the main purchasers of bulk electricity. Successful development of private generation therefore requires 1PPs to sign long-term contracts with the SEBs. If that is to be done without recourse to government guarantees, the SEBs need to be financially strong bodies. This section reviews their overall financial performance, and briefly summarizes the structure of their costs and revenues. Most SEBs are relatively inefficient producers. Unit costs are high, with the exception of financing charges which reflect a heavy reliance on concessionai lending. The Electricity Supply Act (ES Act) requires SEBs to meet a modest minimum rate of return target. However, tariffs are inadequate to enable most SEBs to achieve this target. Tariffs are, in practice, subject to state government approval, and politicians have acted to keep agricultural and household tariffs at low levels. The ES Act requires SEBs to earn at least a 3% return, defined as profit after interest over fixed assets. A more conventional way of measuring the rate of return would be profit before interest over total net assets. Measured on this basis, the SEBs with the best financial performance in India would have made a nominal return of around 12% in 1993-94. However, inflation was running at around 10% during 1993-94, meaning that the best performing SEBs achieved around a 2% real return. Most SEBs did much worse than this. Financial information for poorly performing SEBs is often several years out of date. The position in 1992-93 was that only two SEBs (OSEB and MSEB) achieved a positive rate of return under the definition of the ES Act. Three SEBs had returns between zero a n d - 1 0 % . Six SEBs had returns between - 1 0 % and-20%. Six SEBs had a rate of return below -20%. The estimated (unweighted) average rate of return for all state power utilities in ! 993-94 was -14.3%, a worse performance than in 1992-93. SEBs have been able to continue with such a poor financial performance due to continued government support for investment. In general, state governments have expected them to fund their own operating costs, but not to meet most of the costs of investment. Investment has mainly been funded by state government loans and subsidies, or by planned allocations by public financial institutions. However, the expectation that SEBs will now access more commercial, and more expensive, sources of finance will require them to increase profitability. There are only two ways in which they can do this: reducing costs or increasing revenues. Energy Policy 1995 Volume 23 Number l I
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Financial so'ucture in the Indian power sector: J Carstairs and D Ehrhardt
Table 4 Cost structure for state power utilities, 1993-94 annual plan
Table 5 Tariff structure, 1993--94
Percentage share Power purchase Fuel charges Staff and administration Interest to financial institutions Interest to state governments Depreciation O&M charges Other Total
28.3 27.2 14.6 9.5 9.1 6.0 4.4 0.8 100.0
Industrial Agricultural Domestic Commercial Exports Railway traction Public lighting Other Total
Share of sales (%)
Average tariff (rupees/kWh)
37 29 15 4 2 2 1 10 100
1.70 0.18 0.78 1.64 0.79 1.94 I. 12 1.31 1.10
Cost reduction
(5) Depreciation and O&M charges are relatively minor.
The unit cost per state in 1993-94 varied from Rs0.94 (US¢3.0) per kilowatt hour to Rs3.67 (US¢I 1.7). The average cost was Rsl.41 (US¢4.5). The cost structure for the power utilities is shown in Table 4. This is based on plan estimates, but is consistent with actual costs in earlier years. Performance varies widely between SEBs. There tends to be scope for cost savings in many areas:
The conclusion is that some costs could be reduced, but that others will rise as power moves on to a more commercial footing. London Economics has worked on financial models for a number of SEBs. These often show scope for major cost savings. However, they also tend to show that profitability problems cannot be solved through cost saving alone. The most that can be achieved through cost reductions is to reduce the level of real tariff increases that will be needed to achieve adequate profitability.
(1) Power purchase costs at present are primarily from central government bodies such as NTPC. Power purchase costs are likely to rise steeply for those SEBs which are successful in agreeing IPP contracts against power purchase agreements. (2) Fuel charges can be reduced through improvements to thermal efficiency, and through optimization of dispatch. For a given level of final demand, fuel charges can also be reduced through loss reduction programmes. Losses in some urban areas can rise as high as 50%, but tend to be concealed through lack of metering for bulk transfers, inadequate management attention, and a tendency to attribute losses to (unmetered) sales in rural areas. (3) Despite low unit wage rates, staff and administration costs are high because of the staffing in Indian SEBs. Substantial labour reductions are possible, although unlikely to lead to cost reductions in the short term because of redundancy costs. (4) Interest costs are low, because of a high level of concessional lending. Most SEBs have no equity, and have been funded entirely through loans. In some cases, state governments have agreed to convert some debt to equity, relieving the SEBs of interest payments. Usually, no arrangements have been made for dividends to be paid on this equity, making it more equivalent to a debt write-off. Private power initiatives may prove successful in reducing construction requirements (through higher plant availability), construction costs and the time required, but are likely to be associated with much higher financing costs. 984
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Increasing revenues
Revenue is dominated by electricity sales. Revenue increases will require tariff increases. The average revenue structure of state power utilities is shown in Table 5. The table shows both unit tariffs and the share of sales for 1993-94. A number of points stand out from this table. First, the average revenue per kilowatt hour in 1993/94 was Rsl.l/kWh, or US¢3.5. This compares with a unit production cost of Rs1.41, confirming the poor financial performance of the SEBs. A focus on private power means that the SEBs will be obtaining an increasing share of additional energy under power purchase agreements (PPAs) with private generators. Figures quoted for the costs per kilowatt hour from PPAs currently under discussion are confidential and variable, but Rs2.4/kWh is a figure that has been quoted in connection with some IPP projects. This is an ex-generation price, and the costs o f additional transmission and distribution capacity and o f losses would need to be added on to reach a cost per consumer. It is clear that the marginal cost facing SEBs will increasingly exceed their marginal revenues. The figure of Rs2.4/kWh quoted reflects both capacity and energy charges. After contract signature the marginal cost will be energy charge under the PPA, since capacity payments will not be affected by energy taken. For some SEBs, typical energy charges would exceed their unit revenues. In other words, SEBs will not simply make a
Financial structure in the Indian power sector: J Carsta#:s" and D Ehrhardt
financial loss because of high fixed costs. They will also make an operating loss for each additional kilowatt hour that they sell. One possible solution to this is to rely on increased sales to high-tariff consumers. The Maharashtra utility, MSEB, for example has argued that the Dabhol project can be rendered economic since it will be meeting load growth for mainly industrial and commercial consumers. However, there are difficulties in extending this argument to SEBs in India as a whole. Unit tariffs for industrial consumers are the highest in India. On average however they are below the long-run marginal cost of supply. The same is true of commercial consumers. Some states may have tariffs sufficiently high to justify private power purchase costs provided they meet load growth from these consumers, but it is clearly not true on average for Indian state power utilities. In addition, the lowest tariffs are paid by agricultural/irrigation consumers, and then domestic consumers. There have been attempts to increase these tariffs, including the requirement that SEBs charge at least Rs0.50/kWh to agricultural consumers. However even where successful, this has still meant that agricultural (and often domestic) sales are loss making. Agricultural and domestic consumers account for 44% of sales at present. As shown in Table 1, their share has been growing rapidly. In 1950 they accounted for less than 17% of sales. A strong political commitment remains to extending rural electrification, and supplying further rural households and farmers, and will lead to continued growth in sales to these categories. The conclusion appears to be that the SEBs cannot become commercially strong bodies with their current tariffs. The next section looks at the way SEBs are regulated, and its implication for costs and revenues. S E B ' s current regulation
Regulation of SEBs is carried out through both formal and informal means. The formal regulatory mechanisms include: (1) S.18 of the Electricity (Supply) Act 1948 (ES Act 1948) which makes the board responsible for arranging the supply of electricity within the state, in the most efficient and economical manner, with particular reference to those parts of the state which are not adequately supplied with electricity, and supplying electricity as soon as practicable to a licensee or other person requiring such supply. (2) Under s.29 ES Act 1948 the board must get Central Electricity Authority (CEA) approval for any investments over a specified limit, currently 25 Cr Rs. The CEA is charged with considering the technical and economic suitability of the proposed investment.
(3) Under s.59 ES Act 1948 the board must make at least a 3% post interest return on fixed assets.l (4) S.65 of the ES Act 1948 subjects the borrowing powers of the board to state government control. (5) S.78 ES Act 1948 gives the state government general power to make rules to give effect to the provisions of the Act, including rules governing the powers and terms of appointment of the board members. (6) S.78(A) ES Act 1948 requires the board to be guided by the state government on questions of policy. The courts have interpreted this section as giving state governments considerable power over tariff setting decisions. There has been discussion of establishing regional tariff boards, although the current suggestion is that these boards would have only recommendatory power. The informal mechanisms of regulation stem from the close integration between SEBs and state governments. This has developed for a number of reasons. The first is the very deep reliance of SEBs on state government for investment financing. The second is the common practice of staffing the boards with officials drawn from government, and who will subsequently return to state government service. This close integration means that the boards tend to consult state government and follow their wishes, even when not legally required to. The most obvious example is tariff setting. Under the ES Act, setting tariffs is the board's responsibility. In practice, the board always consults extensively with state government to ensure that tariff proposals are acceptable. This is also a recognition of actual tariff setting powers, since the courts have allowed state governments to overrule SEBs on tariffs. On the other hand the costs and tariffs of private utilities are regulated chiefly by the Sixth Schedule of the ES Act 1948. Private utilities can set tariffs to recover costs plus a return on capital. The return on capital is currently set at the Reserve Bank of India rate, plus 5%. 2 Legally speaking, the private utilities do not require government approval for their tariffs. When they wish to increase tariffs they need only notify the state government and electricity board 60 days in advance, setting out the justification for the increase. I'The Board shall, after taking credit for any subventions from the State Government ... carry on its operations under this Act and adjust its tariffs so as to ensure that the total revenues in any year of account shall, after meeting all expenses properly chargeable to revenues, including operating, maintenance and management expenses, taxes (if any) on income and profits, depreciation and interest payable on all debentures bonds and loans, leave such surplus as is not less than three percent, or such higher percentage, as the State Government may ... specify in this behalf, of the value of the fixed assets of the Board in service at the beginning of such year.' 2For investments made since 1991. The allowable rate of return on capital invested earlier is somewhat lower.
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Financial structure in the Indian power sector: J Carstairs and D Ehrhardt
The private utilities also require board approval for establishing or acquiring a new generating station, or to extend or replace a major unit of any plant or works relating to a generating station, and must follow the directions o f the regional electricity boards and despatch centres (s.44 and s.55 respectively of the ES Act). The main formal control on private utilities' costs is the requirement for their accounts to be inspected by the state's chief electrical engineer at the end of each financial year. This inspection checks that all expenses claimed were properly incurred in the supply of electricity. The key question is the purpose of the expenditure. There is no test o f whether the expenditure provided value for money. There is also provision for the board to constitute a rating committee to examine a licensee's charges where the board is satisfied that the licensee failed to comply with the Sixth Schedule. Again, the formal regulation is supplemented by informal influence. Generally this occurs when the private utilities notify a tariff increase. If the government or SEB find the tariff increase unduly high they discuss it with the private utility, and try to persuade the utility to moderate the planned increase. In some states this influence has been sufficient to damage the financial health of the private utilities. In others, it is more common for the government and the utility to agree on a reduction in planned costs. This allows the tariff rise to be moderated without harming the utility's profitability.
trol operating costs. Tariffs are set to cover actual operating costs, and earn a low return on assets so reducing costs would not increase profits. Only the professionalism of the managers, and desultory informal pressure from state governments and 'host' SEBs provide any check on operating costs. Private utilities have an incentive to overinvest. Since they are allowed to earn a rate of return (which is probably in excess of their cost of capital) on any new investment, the more they invest the more profit they make. Again, informal pressure offers limited control. The coexistence of formal and informal regulatory structures blurs responsibility. Lack of clear responsibility and accountability for decisions leads in time to worse decision making and higher costs. Even in the few cases where competing private utilities exist, the formal and informal power which the SEBs have over private utilities damages competition, and increases risk for private utilities. These factors also push up costs. Overall, the system of regulation in India appears to benefit consumers in the short term, especially in sensitive groups, by limiting tariff rises. However by failing to control costs it leads over the medium term to inefficiency, which leads in turn to higher prices, lack of funds for expansion, and a worse service to customers. Lessons from international best practice suggest the following principles for reform o f the regulatory system:
Assessment
(1) The regulatory system should be made transparent
Informal control by state governments is more powerful than the formal regulatory structures. The main aim of the informal control is to keep tariffs down, especially to sensitive groups such as rural consumers. Historically in India the strength of this pressure has damaged the financial viability of SEBs. Partly as a result of this, the formal regulatory structure now imposes a minimum rate of return on SEBs, in an attempt to ensure that tariffs cover costs. Elsewhere in the world it is more common for regulation to impose a maximum rate of return, to stop utilities pushing up prices to earn excess profits. Regulation of the private utilities under Schedule 6 is an example of a maximum rate of return regime. The regulatory structure keeps prices down in the short term. However it fails to control costs. SEB managers try to keep costs under control, but there is little external pressure or incentive for this. Indeed, the informal influence of state government actually hampers the efforts of managers in most SEBs. For example, political considerations result in SEBs having too many staff, imposing extra costs. Regulation of the private utilities limits the profits they can make, but again there is little incentive to con-
and independent. Only when regulatory decisions are public and predictable can utility managers be held clearly accountable for commercial performance. (2) The reformed system should control costs. Options include: introduction of competition; price cap or other incentive-based regulation (eg comparative competition or sliding scale regulation); or rate of return regulation with strong external scrutiny of costs.
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Sources of finance Table 6 summarizes the barriers SEBs would have to overcome in order to access different sources of finance. Financial obstacles
The first conclusion is that almost all SEBs face considerable obstacles to raising substantial private sector finance without government guarantee. Given a better financial position, SEBs as currently structured would be able to raise loans and issue bonds. They would be able to sign further IPP contracts without recourse to government guarantee.
Financial structure in the Indian power sector." J Carstairs and D Ehrhardt
Table 6 Financing options requirements as at November 1994 Approval needed under Option current law
Legal change required
Financial change required
Debt Bonds Tax flee
State government approval
Taxable
Planning Commission controls total amount
Floating interest
PSU bond issues
Deep discount
SEBI approval tbr public issues
Euro convertibles
State government approval Planning Commission controls total amount PSU bond issues SEBI approval for public issues Foreign exchange approval
Corporatization
Reduce gearing Improve debt cover ratios Gain credit rating
Indian Institutions
State government approval
None
Reducing gearing Improve debt cover ratios
Foreign institutions US$
State government approval Foreign exchange approval
None
Reducing gearing Improve debt cover ratios
Suppliers credit
State government approval
None
Reduce gearing Improve debt cover ratios
na
Corporatization
na
Probably require amendments to Electricity Supply Acts
Improve profitability Increase growth prospects Improve profitability Increase growth prospects
IPPs
State government approval CEA approval
None
Improve cashflows Continue with central government guarantees
Generation rehabilitation leasing/joint ventures
State government directive
Creation of 'generation companies' under s.39 of 1948 Act
Increase revenue Increase profitability
Distribution franchises
na
Amendment to 1948 Act
Increase revenue Increase profitability
na
Corporatization
Increase revenue
None
Reduce gearing Improve debt cover ratios
Gain credit rating
Loans
Equity Ordinary, convertible, preference, GDR Infrastructure funds
Leasing
Energy Policy 1995 Volume 23 Number 11
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Financial structure in the Indian power sector: d Carstairs and D Ehrhardt
SEBs could also sell or lease existing generators to the private sector. This can be done using s.39 of the Electricity (Supply) Act 1948, which provides for transfer of generating stations to generating companies. The state government would have to direct the SEB concerned to transfer existing generators to new generating companies. These companies, which would be incorporated under the Companies Act, could: (1) be sold to the private sector; or (2) become joint ventures between the private sector and the state government (there is an issue whether the SEB could itself hold shares in such a joint venture without a change to the Electricity (Supply) Act 1948); or (3) lease the generating assets on to the private sector. Under any of these options, the private sector would be responsible for operating the stations, and financing rehabilitation. Legal obstacles
The SEBs cannot raise equity capital. There is some legal uncertainty about whether they can enter joint ventures, or lease, sell or franchise existing (non-generation) assets, without amendment to the Electricity (Supply) Act 1948. The least complex change would be corporatize 3 all or parts of existing SEBs. This would give them the legal freedom to issue shares, and to dispose of assets. Once an SEB has overcome the present legal and financial barriers to raising private sector finance, it will need to balance the cost of the financing options outlined with their impact on capital structure and business structure, as outlined in the following sections. Optimal capital sources
Debt finance is cheaper than equity. At first sight this suggests that SEBs should try to raise as much finance as possible through debt - in other words that they should aim for a very high gearing. Obviously, this approach is too simplistic. In fact, as the proportion of debt in a company's capital structure increases, the riskiness of returns to equity holders increases. Interest payments are fixed, so the larger the interest payment the greater the variability of the remaining cashflow left for shareholders. Equity holders therefore demand a higher return to compensate for the higher risk. Modigliani and Miller showed that the rise in the cost of equity capital exactly offsets the gain from using
3That is incorporate it as a company under the Companies Act.
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cheaper debt finance. The Modigliani-Miller proposition therefore states that a company's cost of capital is independent of its capital structure. The Modigliani-Miller proposition is now generally accepted as a good first approximation- companies cannot get cheaper finance just by switching from equity to debt. But other more subtle arguments mean that in fact the capital structure adopted by the SEBs will affect their cost of capital as they start to become more commercial. The most important factors are:
(1) Bankruptcy costs - the higher the level of debt, the greater the chance of bankruptcy. Bankruptcy destroys value, and investors need compensation for running the risk of bankruptcy. The SEB's current very high gearing means that a reduction in operating cashflows could force them into bankruptcy, leaving investors with large losses. In this situation, investors either will not supply the SEBs with capital, or will charge a premium for doing so. Therefore reducing the SEB's current high gearing is likely to increase their access to finance, and reduce their cost of capital. The factors which would limit that decrease in gearing are:
(21 Tax - the SEBs could start to pay corporate tax as a result of reforms. Interest payments are an expense for company tax purposes, while dividend payments are not. The tax system therefore makes debt finance cheaper than equity. (3) Monitoring - the SEB's future shareholders may seek relatively high gearing levels to encourage managers to perform. Shareholders worry that managers may indulge in expensive perks, carry out new investments simply for prestige or interest value, or otherwise not work hard enough to keep costs down. A high proportion of debt in a company s capital structure can reduce these problems. Managers have to work hard to meet the high interest payments, and cannot afford indulgences. By making managers more efficient, the capital structure can affect the company's profitability. The optimal level o f gearing depends on the relative strengths of these effects. It is some time until SEBs will operate as fully commercial bodies, if indeed they survive reforms developing in the Indian power sector. They will have much greater access to commercial finance once they become profitable, and subject to well-structured regulation that provides incentives for efficiency. They will then need to decide on their optimal capital structure taking into account the desired industry and businesses structures,
Financial structure in the Indian power sector: J Carstairs and D Ehrhardt
Costs
Disaggregated Private ownership
.
~
Integrated
. , ~
Private ownership
Price cap regulation
~
Rate of return
Competition
,
Industry structure ~
Monopoly regulation :.
I
Financial structure
Figure 1 Industrystructure and financial structure
regulatory regime, etc. International experience suggests that the optimal gearing is likely to be in the 50% to 75% range. This is below current levels for most SEBs, but above levels that have been advocated by some commentators. There are two options to reduce gearing quickly: (1) debt conversions or write-offs; and (2) disposal of assets. Further debt conversions or write-offs depend on the state government. While benefiting the SEBs, this option would cost the state governments in forgone interest revenue. If SEBs became profitable bodies and paid dividends, debt conversion would become a more attractive option. Sale, leasing, or sale and lease back of assets are likely to be effective ways to improve gearing. Existing generating assets could be disposed of using the s.39 of the Electricity (Supply) Act 1948, as discussed above. It seems likely that disposal of other assets would require corporatization or other legal change.
(1) A rate of return regulated utility can support higher gearing, and have a lower cost of capital, than a utility facing competition or price cap regulation. (2) The capital structure and financing costs of disaggregated generating and distribution companies will differ from those of a vertically integrated utility, and from each other. (3) Greater private sector involvement may increase financing costs. Figure 1 illustrates some of the key trade offs. An industry which is disaggregated, privately owned, and competitive or price cap regulated is likely to have higher financing costs and lower gearing than a publicly owned, vertically integrated, rate of return regulated monopoly. On the other hand, introducing competition, private ownership, and regulatory incentives for efficiency are likely to lead to lower operating costs, lower capital investment costs, and improved customer service. The challenge is to find the optimal trade off between these factors.
Business and industry structure
Conclusion on financing investment and capital structure
Questions of sector structure and regulator are crucially important for capital structure and financing. For example:
The SEBs face significant obstacles in raising finance, or in signing further IPPs, since: Energy Policy 1995 Volume 23 Number 11
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Financial structure in the Indian power sector: J Carstairs and D Ehrhardt
(1) Profitability is too low. (2) Gearing is too high. (3) It appears that they cannot legally dispose of assets in connection with restructuring (except generation assets using s.39 of 1948 Act). (4) They cannot raise equity finance. Overcoming these problems is likely to require a package of reforms including: (1) industry restructuring to unleash cost savings;
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(2) increases in revenue; (3) legal reforms such as corporatization to allow SEBs to dispose of assets and raise equity; (4) possible further debt write-offs and conversions. It is clear that SEBs will need to reduce gearing, and increase private finance of expansion. However it is not clear up to what point this restructuring should be pursued. The decision on the optimal capital structure cannot be taken in isolation. It is one element in a total reform package.
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Energy Polio'. Vol. 23. No. 11. pp. 981-990. 1995 Copyright ;t'i 1995 Elsevier Science Ltd Printed in Greal Britain. All rights reserved 0301-4215/95 $10.00 + 0.00
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0301-4215(95)00128-X
Financial structure in the Indian power sector Jamie Carstairs and David Ehrhardt London Economics Ltd, 66 Chiltern Street, London, WIM 1PR, UK
In India, the private power initiative of 1991 has offered one solution to the financing problem the private financing of generation against long-term power purchase agreements. However, this approach encounters a major problem, the financial weakness of the purchasing agents, the state electricity boards, that play a dominant role in most state's power sectors. At present the SEBs are mostly loss making; even the best performers realize returns on assets well below the cost of capital that they now face. The situation is likely to become worse as costs rise, further weakening the ability of the SEBs to sign credible long-term power purchase contracts. The private sector has responded by trying to reduce its exposure to SEBs through obtaining guarantees from state and central governments. There are a number of responses to this problem. The SEBs could try to become financially stronger through both cost reduction and increased revenues from higher tariffs and better collection. However, to make the SEBs and EDs into credible long-term power purchasers, power sector reform and regulation is needed. As these actions will take time, other responses could be investigated such as reducing the role of state power utilities by, for example, giving private generators direct access to industrial consumers. The long-term solution requires more profitable SEBs, if these bodies are to continue to play a dominant role in state-level electricity provision. Profitable SEBs will have access to finance from a range of domestic and international sources. The article finishes with consideration of the factors that will affect the optimal capital structure for SEBs. Kevwords: Electricity; Finance; India
The Indian power sector has an enormous financing requirement. Its rapid expansion over the last forty years has mainly been financed through grant and soft loans from the public sector in different forms. That source of finance is now drying up, forcing the sector to look for alternatives. The private power initiative since 1991 has offered one solution to the financing problem, through private financing of generation against long-term power purchase agreements. However, it has not yet addressed the fundamental problem, which is that state electricity boards (SEBs) are too financially weak to borrow from commercial sources and therefore also too weak to sign longterm contracts. The private sector has responded by trying to reduce its exposure to SEBs, in particular through state and centre guarantees. Despite a host of Memoranda of Understanding and a huge wave of interest in private financing, the basic con-
ditions for private financing have not yet been met. The key condition for private investment in generation to proceed is that there is a credible body to sign the contract. In all states that remains missing, and as a result the intention to shift power financing off the books of the public sector is still a long way from being met. In most states the SEB, or electricity department (ED), has a dominant role. The SEBs are large enterprises. Many have turnover of several hundred million dollars per year, and the largest have a turnover exceeding US$1 billion. At present they are mostly loss making. The best performers realize a positive return on assets, but at levels well below the cost of capital that they now face. The private power policy therefore faces a problem which it is still a long way from resolving. The intention is that state power utilities should contract for new generation, without recourse to public funds or guarantees. Energy PolicT 1995 Volume 23 Number 11
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Financial structule in the Indian power sector: J Carstairs and D Ehrhardt
Table I Shares of electricity consumption (%) First plan
Eighth plan
Industrial Agricultural Domestic Commercial Other
42.0 28.2 17.2 5.8 6.8
62.6 3.9 12.6 7.5 13.4
However, the utilities are mostly loss making, and likely to become more so as the costs of power purchase increase. They can reduce costs, through efficiency gains, and increase revenues through higher tariffs and better collection. These actions will take time. The financial weakness of the state utilities is likely to stall private power development for some years. There are two possible responses to this problem. The role of state power utilities could be reduced, through a variety of market mechanisms giving private generators direct access to industrial consumers. Alternatively, the SEBs and EDs could be transformed into suitable bodies to act as power purchasers. That means not just making them profitable, but setting in place long-term regulation that will keep them profitable provided they operate efficiently. The paper assumes that, in some states at least, the SEB or ED will continue to play a major role. The focus is on how to improve SEBs rather than on how to replace them. Given this assumption, the purpose of this paper is to consider what financial options are open to the state power utilities; to look at the kind of changes that would be required for them to access new financial sources; and to set out some preliminary thoughts on an optimal financial structure.
Financing requirement The power sector in India has grown rapidly over the last 40 years. The utilities installed capacity has increased from 1713 MW in 1950 to 7 6 7 1 8 M W by March 1994 and generation from 5100 GWh to 323 323 GWh. In addition to rapid population growth, per capita consumption has grown from 15 kWh in 1950 to over 270 kWh now.
This period of growth has also seen a shift in the nature of electricity consumption. The power sector has moved from being dominated by industrial sales to a larger share for residential and agricultural consumers (see Table 1). Although demand forecasts are made periodically (the 15th Power Survey representing the latest example), it is difficult to turn this into an investment requirement for a variety of reasons. First, the Indian power sector has become accustomed to severe financing restrictions. As a result, planning tends to focus on disbursement of 982
Energy Policy 1995 Volume 23 Number 11
Table 2 Additional capacity required Peripd Capacity requirement (MW) Eighth Plan Ninth Plan Tenth Plan
30 538 37 400~48 400 45 000-53 000
the funds available, rather than on total requirements. To use the jargon of the Indian power sector, there has been a bigger role for 'resource based planning' than for 'needs based planning'. This results in a planning process that disburses the funds available but shows a capacity gap in megawatts. Less attention has been given to preparing a forecast of total investment requirements to meet unconstrained demand, leading to a financing gap. There remains a high degree of coordination and centralization in the Indian power sector. The formal responsibility for preparing least cost expansion plans for the states lies with the Central Electricity Authority, the CEA. However, this role has not been undertaken very actively, again because of the rather academic nature of least cost expansion plans whose costs greatly exceed the sums available. A third element of the lack of a clear expansion plan has been the tendency to develop private power proposals on a negotiated rather than competed basis. The result is that proposed investments do not emerge from an overall planned expansion, and competition for identified projects. Rather they spring from a dialogue o~en initiated by project sponsors rather than the utilities themselves. It is, however, possible to make minimum estimates of magnitude of the investment requirement. Demand forecasting and investment planning in India tend to be structured around five-year planning periods. Table 2 shows the estimated requirements for additional capacity during the Eighth, Ninth and Tenth Plans. These run from 1992/93-1996/97, 1997/98-2001/02 and 2002/032006/07 respectively. It should be noted that the figure for the Eighth Plan period already represents a concession to the scale of funds available. The required capacity addition was originally estimated at over 35 000 MW, and was subsequently reduced in line with the level considered feasible. There is no accurate way of estimating the cost of these proposed investments. However, at least an approximate estimate is required to show the scale of the financing problem. We have assumed that these capacity additions will take the form of coal-fired plant, with unit size of 300 MW and a cost per megawatt of US$1.3 million (including FGD). This cost estimate is based on de-
Financial structure in the hldian power sector: J Cai:s'tairs and D Ehrhardt
Financial position
Table 3 State power bodies Department of electricity board Andhra Pradesh Arunachal Pradesh Assam Bihar Goa Gujarat Haryana Himachal Pradesh Jammu and Kashmir Kamataka Kerala Madhya Pradesh Maharashtra Manipur Meghalaya Mizoram Nagaland Orissa Punjab Rajasthan Sikkim Tamil Nadu Tripura Uttar Pradesh Bengal
APSEB ED ASEB BSEB ED GEB HSEB HPSEB PDD KEB KSEB MPEB MSEB ED MeSEB ED ED OSEB PSEB RSEB ED TNEB ED UPSEB WBSEB
Power corporation
Licensee
APGPC
BHPC, TVNL G PCL
AECO
KPC
TPC
OPGC
U PRVUN WBPDC
tailed cost estimates for investments currently under consideration. Using this simple rule of thumb, the annual investment requirements would be around US$7.9 billion during the Eighth Plan, US$9.7-12.6 billion during the Ninth Plan and US$11.7-13.8 billion during the Tenth Plan.
State power utilities SEBs play a key role in the Indian power sector. This section briefly summarizes the responsibility for power supply within different states. It then looks in greater detail at their overall financial performance, and at the legislation governing SEBs. India is made up of 25 states and 7 union territories. In all union territories except Delhi power is the responsibility of an electricity department, while in Delhi it is undertaken by DESU. Within the states the responsibility lies in most cases with the SEB (although a number of the smaller states operate through an electricity department). Though the states have their own generating facilities, they obtain a large share of their supplies from the NTPC. The Electricity Supply Act also allows for the creation of power corporations, which carry out generation and in some cases bulk supply to major consumers. There are also a few private companies that are licensed to operate in the power sector. Table 3 summarizes the state level bodies involved.
In most large states the SEBs have a monopoly of supply. Unless there is a substantial change in industry structure, they will continue to be the main purchasers of bulk electricity. Successful development of private generation therefore requires 1PPs to sign long-term contracts with the SEBs. If that is to be done without recourse to government guarantees, the SEBs need to be financially strong bodies. This section reviews their overall financial performance, and briefly summarizes the structure of their costs and revenues. Most SEBs are relatively inefficient producers. Unit costs are high, with the exception of financing charges which reflect a heavy reliance on concessionai lending. The Electricity Supply Act (ES Act) requires SEBs to meet a modest minimum rate of return target. However, tariffs are inadequate to enable most SEBs to achieve this target. Tariffs are, in practice, subject to state government approval, and politicians have acted to keep agricultural and household tariffs at low levels. The ES Act requires SEBs to earn at least a 3% return, defined as profit after interest over fixed assets. A more conventional way of measuring the rate of return would be profit before interest over total net assets. Measured on this basis, the SEBs with the best financial performance in India would have made a nominal return of around 12% in 1993-94. However, inflation was running at around 10% during 1993-94, meaning that the best performing SEBs achieved around a 2% real return. Most SEBs did much worse than this. Financial information for poorly performing SEBs is often several years out of date. The position in 1992-93 was that only two SEBs (OSEB and MSEB) achieved a positive rate of return under the definition of the ES Act. Three SEBs had returns between zero a n d - 1 0 % . Six SEBs had returns between - 1 0 % and-20%. Six SEBs had a rate of return below -20%. The estimated (unweighted) average rate of return for all state power utilities in ! 993-94 was -14.3%, a worse performance than in 1992-93. SEBs have been able to continue with such a poor financial performance due to continued government support for investment. In general, state governments have expected them to fund their own operating costs, but not to meet most of the costs of investment. Investment has mainly been funded by state government loans and subsidies, or by planned allocations by public financial institutions. However, the expectation that SEBs will now access more commercial, and more expensive, sources of finance will require them to increase profitability. There are only two ways in which they can do this: reducing costs or increasing revenues. Energy Policy 1995 Volume 23 Number l I
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Financial so'ucture in the Indian power sector: J Carstairs and D Ehrhardt
Table 4 Cost structure for state power utilities, 1993-94 annual plan
Table 5 Tariff structure, 1993--94
Percentage share Power purchase Fuel charges Staff and administration Interest to financial institutions Interest to state governments Depreciation O&M charges Other Total
28.3 27.2 14.6 9.5 9.1 6.0 4.4 0.8 100.0
Industrial Agricultural Domestic Commercial Exports Railway traction Public lighting Other Total
Share of sales (%)
Average tariff (rupees/kWh)
37 29 15 4 2 2 1 10 100
1.70 0.18 0.78 1.64 0.79 1.94 I. 12 1.31 1.10
Cost reduction
(5) Depreciation and O&M charges are relatively minor.
The unit cost per state in 1993-94 varied from Rs0.94 (US¢3.0) per kilowatt hour to Rs3.67 (US¢I 1.7). The average cost was Rsl.41 (US¢4.5). The cost structure for the power utilities is shown in Table 4. This is based on plan estimates, but is consistent with actual costs in earlier years. Performance varies widely between SEBs. There tends to be scope for cost savings in many areas:
The conclusion is that some costs could be reduced, but that others will rise as power moves on to a more commercial footing. London Economics has worked on financial models for a number of SEBs. These often show scope for major cost savings. However, they also tend to show that profitability problems cannot be solved through cost saving alone. The most that can be achieved through cost reductions is to reduce the level of real tariff increases that will be needed to achieve adequate profitability.
(1) Power purchase costs at present are primarily from central government bodies such as NTPC. Power purchase costs are likely to rise steeply for those SEBs which are successful in agreeing IPP contracts against power purchase agreements. (2) Fuel charges can be reduced through improvements to thermal efficiency, and through optimization of dispatch. For a given level of final demand, fuel charges can also be reduced through loss reduction programmes. Losses in some urban areas can rise as high as 50%, but tend to be concealed through lack of metering for bulk transfers, inadequate management attention, and a tendency to attribute losses to (unmetered) sales in rural areas. (3) Despite low unit wage rates, staff and administration costs are high because of the staffing in Indian SEBs. Substantial labour reductions are possible, although unlikely to lead to cost reductions in the short term because of redundancy costs. (4) Interest costs are low, because of a high level of concessional lending. Most SEBs have no equity, and have been funded entirely through loans. In some cases, state governments have agreed to convert some debt to equity, relieving the SEBs of interest payments. Usually, no arrangements have been made for dividends to be paid on this equity, making it more equivalent to a debt write-off. Private power initiatives may prove successful in reducing construction requirements (through higher plant availability), construction costs and the time required, but are likely to be associated with much higher financing costs. 984
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Increasing revenues
Revenue is dominated by electricity sales. Revenue increases will require tariff increases. The average revenue structure of state power utilities is shown in Table 5. The table shows both unit tariffs and the share of sales for 1993-94. A number of points stand out from this table. First, the average revenue per kilowatt hour in 1993/94 was Rsl.l/kWh, or US¢3.5. This compares with a unit production cost of Rs1.41, confirming the poor financial performance of the SEBs. A focus on private power means that the SEBs will be obtaining an increasing share of additional energy under power purchase agreements (PPAs) with private generators. Figures quoted for the costs per kilowatt hour from PPAs currently under discussion are confidential and variable, but Rs2.4/kWh is a figure that has been quoted in connection with some IPP projects. This is an ex-generation price, and the costs o f additional transmission and distribution capacity and o f losses would need to be added on to reach a cost per consumer. It is clear that the marginal cost facing SEBs will increasingly exceed their marginal revenues. The figure of Rs2.4/kWh quoted reflects both capacity and energy charges. After contract signature the marginal cost will be energy charge under the PPA, since capacity payments will not be affected by energy taken. For some SEBs, typical energy charges would exceed their unit revenues. In other words, SEBs will not simply make a
Financial structure in the Indian power sector: J Carsta#:s" and D Ehrhardt
financial loss because of high fixed costs. They will also make an operating loss for each additional kilowatt hour that they sell. One possible solution to this is to rely on increased sales to high-tariff consumers. The Maharashtra utility, MSEB, for example has argued that the Dabhol project can be rendered economic since it will be meeting load growth for mainly industrial and commercial consumers. However, there are difficulties in extending this argument to SEBs in India as a whole. Unit tariffs for industrial consumers are the highest in India. On average however they are below the long-run marginal cost of supply. The same is true of commercial consumers. Some states may have tariffs sufficiently high to justify private power purchase costs provided they meet load growth from these consumers, but it is clearly not true on average for Indian state power utilities. In addition, the lowest tariffs are paid by agricultural/irrigation consumers, and then domestic consumers. There have been attempts to increase these tariffs, including the requirement that SEBs charge at least Rs0.50/kWh to agricultural consumers. However even where successful, this has still meant that agricultural (and often domestic) sales are loss making. Agricultural and domestic consumers account for 44% of sales at present. As shown in Table 1, their share has been growing rapidly. In 1950 they accounted for less than 17% of sales. A strong political commitment remains to extending rural electrification, and supplying further rural households and farmers, and will lead to continued growth in sales to these categories. The conclusion appears to be that the SEBs cannot become commercially strong bodies with their current tariffs. The next section looks at the way SEBs are regulated, and its implication for costs and revenues. S E B ' s current regulation
Regulation of SEBs is carried out through both formal and informal means. The formal regulatory mechanisms include: (1) S.18 of the Electricity (Supply) Act 1948 (ES Act 1948) which makes the board responsible for arranging the supply of electricity within the state, in the most efficient and economical manner, with particular reference to those parts of the state which are not adequately supplied with electricity, and supplying electricity as soon as practicable to a licensee or other person requiring such supply. (2) Under s.29 ES Act 1948 the board must get Central Electricity Authority (CEA) approval for any investments over a specified limit, currently 25 Cr Rs. The CEA is charged with considering the technical and economic suitability of the proposed investment.
(3) Under s.59 ES Act 1948 the board must make at least a 3% post interest return on fixed assets.l (4) S.65 of the ES Act 1948 subjects the borrowing powers of the board to state government control. (5) S.78 ES Act 1948 gives the state government general power to make rules to give effect to the provisions of the Act, including rules governing the powers and terms of appointment of the board members. (6) S.78(A) ES Act 1948 requires the board to be guided by the state government on questions of policy. The courts have interpreted this section as giving state governments considerable power over tariff setting decisions. There has been discussion of establishing regional tariff boards, although the current suggestion is that these boards would have only recommendatory power. The informal mechanisms of regulation stem from the close integration between SEBs and state governments. This has developed for a number of reasons. The first is the very deep reliance of SEBs on state government for investment financing. The second is the common practice of staffing the boards with officials drawn from government, and who will subsequently return to state government service. This close integration means that the boards tend to consult state government and follow their wishes, even when not legally required to. The most obvious example is tariff setting. Under the ES Act, setting tariffs is the board's responsibility. In practice, the board always consults extensively with state government to ensure that tariff proposals are acceptable. This is also a recognition of actual tariff setting powers, since the courts have allowed state governments to overrule SEBs on tariffs. On the other hand the costs and tariffs of private utilities are regulated chiefly by the Sixth Schedule of the ES Act 1948. Private utilities can set tariffs to recover costs plus a return on capital. The return on capital is currently set at the Reserve Bank of India rate, plus 5%. 2 Legally speaking, the private utilities do not require government approval for their tariffs. When they wish to increase tariffs they need only notify the state government and electricity board 60 days in advance, setting out the justification for the increase. I'The Board shall, after taking credit for any subventions from the State Government ... carry on its operations under this Act and adjust its tariffs so as to ensure that the total revenues in any year of account shall, after meeting all expenses properly chargeable to revenues, including operating, maintenance and management expenses, taxes (if any) on income and profits, depreciation and interest payable on all debentures bonds and loans, leave such surplus as is not less than three percent, or such higher percentage, as the State Government may ... specify in this behalf, of the value of the fixed assets of the Board in service at the beginning of such year.' 2For investments made since 1991. The allowable rate of return on capital invested earlier is somewhat lower.
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Financial structure in the Indian power sector: J Carstairs and D Ehrhardt
The private utilities also require board approval for establishing or acquiring a new generating station, or to extend or replace a major unit of any plant or works relating to a generating station, and must follow the directions o f the regional electricity boards and despatch centres (s.44 and s.55 respectively of the ES Act). The main formal control on private utilities' costs is the requirement for their accounts to be inspected by the state's chief electrical engineer at the end of each financial year. This inspection checks that all expenses claimed were properly incurred in the supply of electricity. The key question is the purpose of the expenditure. There is no test o f whether the expenditure provided value for money. There is also provision for the board to constitute a rating committee to examine a licensee's charges where the board is satisfied that the licensee failed to comply with the Sixth Schedule. Again, the formal regulation is supplemented by informal influence. Generally this occurs when the private utilities notify a tariff increase. If the government or SEB find the tariff increase unduly high they discuss it with the private utility, and try to persuade the utility to moderate the planned increase. In some states this influence has been sufficient to damage the financial health of the private utilities. In others, it is more common for the government and the utility to agree on a reduction in planned costs. This allows the tariff rise to be moderated without harming the utility's profitability.
trol operating costs. Tariffs are set to cover actual operating costs, and earn a low return on assets so reducing costs would not increase profits. Only the professionalism of the managers, and desultory informal pressure from state governments and 'host' SEBs provide any check on operating costs. Private utilities have an incentive to overinvest. Since they are allowed to earn a rate of return (which is probably in excess of their cost of capital) on any new investment, the more they invest the more profit they make. Again, informal pressure offers limited control. The coexistence of formal and informal regulatory structures blurs responsibility. Lack of clear responsibility and accountability for decisions leads in time to worse decision making and higher costs. Even in the few cases where competing private utilities exist, the formal and informal power which the SEBs have over private utilities damages competition, and increases risk for private utilities. These factors also push up costs. Overall, the system of regulation in India appears to benefit consumers in the short term, especially in sensitive groups, by limiting tariff rises. However by failing to control costs it leads over the medium term to inefficiency, which leads in turn to higher prices, lack of funds for expansion, and a worse service to customers. Lessons from international best practice suggest the following principles for reform o f the regulatory system:
Assessment
(1) The regulatory system should be made transparent
Informal control by state governments is more powerful than the formal regulatory structures. The main aim of the informal control is to keep tariffs down, especially to sensitive groups such as rural consumers. Historically in India the strength of this pressure has damaged the financial viability of SEBs. Partly as a result of this, the formal regulatory structure now imposes a minimum rate of return on SEBs, in an attempt to ensure that tariffs cover costs. Elsewhere in the world it is more common for regulation to impose a maximum rate of return, to stop utilities pushing up prices to earn excess profits. Regulation of the private utilities under Schedule 6 is an example of a maximum rate of return regime. The regulatory structure keeps prices down in the short term. However it fails to control costs. SEB managers try to keep costs under control, but there is little external pressure or incentive for this. Indeed, the informal influence of state government actually hampers the efforts of managers in most SEBs. For example, political considerations result in SEBs having too many staff, imposing extra costs. Regulation of the private utilities limits the profits they can make, but again there is little incentive to con-
and independent. Only when regulatory decisions are public and predictable can utility managers be held clearly accountable for commercial performance. (2) The reformed system should control costs. Options include: introduction of competition; price cap or other incentive-based regulation (eg comparative competition or sliding scale regulation); or rate of return regulation with strong external scrutiny of costs.
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Energy Policy 1995 Volume 23 Number 11
Sources of finance Table 6 summarizes the barriers SEBs would have to overcome in order to access different sources of finance. Financial obstacles
The first conclusion is that almost all SEBs face considerable obstacles to raising substantial private sector finance without government guarantee. Given a better financial position, SEBs as currently structured would be able to raise loans and issue bonds. They would be able to sign further IPP contracts without recourse to government guarantee.
Financial structure in the Indian power sector." J Carstairs and D Ehrhardt
Table 6 Financing options requirements as at November 1994 Approval needed under Option current law
Legal change required
Financial change required
Debt Bonds Tax flee
State government approval
Taxable
Planning Commission controls total amount
Floating interest
PSU bond issues
Deep discount
SEBI approval tbr public issues
Euro convertibles
State government approval Planning Commission controls total amount PSU bond issues SEBI approval for public issues Foreign exchange approval
Corporatization
Reduce gearing Improve debt cover ratios Gain credit rating
Indian Institutions
State government approval
None
Reducing gearing Improve debt cover ratios
Foreign institutions US$
State government approval Foreign exchange approval
None
Reducing gearing Improve debt cover ratios
Suppliers credit
State government approval
None
Reduce gearing Improve debt cover ratios
na
Corporatization
na
Probably require amendments to Electricity Supply Acts
Improve profitability Increase growth prospects Improve profitability Increase growth prospects
IPPs
State government approval CEA approval
None
Improve cashflows Continue with central government guarantees
Generation rehabilitation leasing/joint ventures
State government directive
Creation of 'generation companies' under s.39 of 1948 Act
Increase revenue Increase profitability
Distribution franchises
na
Amendment to 1948 Act
Increase revenue Increase profitability
na
Corporatization
Increase revenue
None
Reduce gearing Improve debt cover ratios
Gain credit rating
Loans
Equity Ordinary, convertible, preference, GDR Infrastructure funds
Leasing
Energy Policy 1995 Volume 23 Number 11
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Financial structure in the Indian power sector: d Carstairs and D Ehrhardt
SEBs could also sell or lease existing generators to the private sector. This can be done using s.39 of the Electricity (Supply) Act 1948, which provides for transfer of generating stations to generating companies. The state government would have to direct the SEB concerned to transfer existing generators to new generating companies. These companies, which would be incorporated under the Companies Act, could: (1) be sold to the private sector; or (2) become joint ventures between the private sector and the state government (there is an issue whether the SEB could itself hold shares in such a joint venture without a change to the Electricity (Supply) Act 1948); or (3) lease the generating assets on to the private sector. Under any of these options, the private sector would be responsible for operating the stations, and financing rehabilitation. Legal obstacles
The SEBs cannot raise equity capital. There is some legal uncertainty about whether they can enter joint ventures, or lease, sell or franchise existing (non-generation) assets, without amendment to the Electricity (Supply) Act 1948. The least complex change would be corporatize 3 all or parts of existing SEBs. This would give them the legal freedom to issue shares, and to dispose of assets. Once an SEB has overcome the present legal and financial barriers to raising private sector finance, it will need to balance the cost of the financing options outlined with their impact on capital structure and business structure, as outlined in the following sections. Optimal capital sources
Debt finance is cheaper than equity. At first sight this suggests that SEBs should try to raise as much finance as possible through debt - in other words that they should aim for a very high gearing. Obviously, this approach is too simplistic. In fact, as the proportion of debt in a company's capital structure increases, the riskiness of returns to equity holders increases. Interest payments are fixed, so the larger the interest payment the greater the variability of the remaining cashflow left for shareholders. Equity holders therefore demand a higher return to compensate for the higher risk. Modigliani and Miller showed that the rise in the cost of equity capital exactly offsets the gain from using
3That is incorporate it as a company under the Companies Act.
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Energy Poli~ y 1995 Volume 23 Number l I
cheaper debt finance. The Modigliani-Miller proposition therefore states that a company's cost of capital is independent of its capital structure. The Modigliani-Miller proposition is now generally accepted as a good first approximation- companies cannot get cheaper finance just by switching from equity to debt. But other more subtle arguments mean that in fact the capital structure adopted by the SEBs will affect their cost of capital as they start to become more commercial. The most important factors are:
(1) Bankruptcy costs - the higher the level of debt, the greater the chance of bankruptcy. Bankruptcy destroys value, and investors need compensation for running the risk of bankruptcy. The SEB's current very high gearing means that a reduction in operating cashflows could force them into bankruptcy, leaving investors with large losses. In this situation, investors either will not supply the SEBs with capital, or will charge a premium for doing so. Therefore reducing the SEB's current high gearing is likely to increase their access to finance, and reduce their cost of capital. The factors which would limit that decrease in gearing are:
(21 Tax - the SEBs could start to pay corporate tax as a result of reforms. Interest payments are an expense for company tax purposes, while dividend payments are not. The tax system therefore makes debt finance cheaper than equity. (3) Monitoring - the SEB's future shareholders may seek relatively high gearing levels to encourage managers to perform. Shareholders worry that managers may indulge in expensive perks, carry out new investments simply for prestige or interest value, or otherwise not work hard enough to keep costs down. A high proportion of debt in a company s capital structure can reduce these problems. Managers have to work hard to meet the high interest payments, and cannot afford indulgences. By making managers more efficient, the capital structure can affect the company's profitability. The optimal level o f gearing depends on the relative strengths of these effects. It is some time until SEBs will operate as fully commercial bodies, if indeed they survive reforms developing in the Indian power sector. They will have much greater access to commercial finance once they become profitable, and subject to well-structured regulation that provides incentives for efficiency. They will then need to decide on their optimal capital structure taking into account the desired industry and businesses structures,
Financial structure in the Indian power sector: J Carstairs and D Ehrhardt
Costs
Disaggregated Private ownership
.
~
Integrated
. , ~
Private ownership
Price cap regulation
~
Rate of return
Competition
,
Industry structure ~
Monopoly regulation :.
I
Financial structure
Figure 1 Industrystructure and financial structure
regulatory regime, etc. International experience suggests that the optimal gearing is likely to be in the 50% to 75% range. This is below current levels for most SEBs, but above levels that have been advocated by some commentators. There are two options to reduce gearing quickly: (1) debt conversions or write-offs; and (2) disposal of assets. Further debt conversions or write-offs depend on the state government. While benefiting the SEBs, this option would cost the state governments in forgone interest revenue. If SEBs became profitable bodies and paid dividends, debt conversion would become a more attractive option. Sale, leasing, or sale and lease back of assets are likely to be effective ways to improve gearing. Existing generating assets could be disposed of using the s.39 of the Electricity (Supply) Act 1948, as discussed above. It seems likely that disposal of other assets would require corporatization or other legal change.
(1) A rate of return regulated utility can support higher gearing, and have a lower cost of capital, than a utility facing competition or price cap regulation. (2) The capital structure and financing costs of disaggregated generating and distribution companies will differ from those of a vertically integrated utility, and from each other. (3) Greater private sector involvement may increase financing costs. Figure 1 illustrates some of the key trade offs. An industry which is disaggregated, privately owned, and competitive or price cap regulated is likely to have higher financing costs and lower gearing than a publicly owned, vertically integrated, rate of return regulated monopoly. On the other hand, introducing competition, private ownership, and regulatory incentives for efficiency are likely to lead to lower operating costs, lower capital investment costs, and improved customer service. The challenge is to find the optimal trade off between these factors.
Business and industry structure
Conclusion on financing investment and capital structure
Questions of sector structure and regulator are crucially important for capital structure and financing. For example:
The SEBs face significant obstacles in raising finance, or in signing further IPPs, since: Energy Policy 1995 Volume 23 Number 11
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Financial structure in the Indian power sector: J Carstairs and D Ehrhardt
(1) Profitability is too low. (2) Gearing is too high. (3) It appears that they cannot legally dispose of assets in connection with restructuring (except generation assets using s.39 of 1948 Act). (4) They cannot raise equity finance. Overcoming these problems is likely to require a package of reforms including: (1) industry restructuring to unleash cost savings;
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Energo,PolioT 1995 Volume 23 Number 11
(2) increases in revenue; (3) legal reforms such as corporatization to allow SEBs to dispose of assets and raise equity; (4) possible further debt write-offs and conversions. It is clear that SEBs will need to reduce gearing, and increase private finance of expansion. However it is not clear up to what point this restructuring should be pursued. The decision on the optimal capital structure cannot be taken in isolation. It is one element in a total reform package.