DSIJ Mindshare

A Coal Roadblock

There will be very few incidents in corporate history where something that is offered at a discount of over 50 per cent to the market value would have few takers. Coal as a commodity, which has been in the eye of a storm for quite some time now, has its own importance in the overall economic scenario. If you were to get it at a 50 per cent discount to the market price, why would you not want to jump at the opportunity? Before this question can be answered, it is important to put the whole discussion in the correct context.

Coal can be procured at a price that suits its quality. Largely, the quality of Indian coal is of a lower degree than what can be procured from markets abroad. This is the predominant reason why coal prices in India are lesser than those abroad. The second reason why coal in India is cheap as compared to that in the international markets is that Coal India (CIL), which controls almost 80 per cent of the reserves, does not have to pay any extra amount to the government for the prospecting of coal from the mines. For instance, against the current international market price of USD 85 per tonne, CIL’s average realisations during FY12 stood at only USD 26 per tonne, which means a discount of almost 70 per cent to the international price.

Within the Indian market, the coal prices are determined either by way of e-auctions or by way of FSAs (fuel supply agreements). Now, the government has come out with a clear directive asking CIL to sign FSAs with the power producers that have come up after April, 2009 and who will be setting up their plants till March, 2015. These FSAs must ensure that CIL supplies at least 80 per cent of the committed coal delivery. What emerges loud and clear is that the government is keen on ensuring coal supply to power producers by obliging CIL to stick to its commitment.

As it is, the price of coal in India is at a discount to the international price. Even within that, the price that is being offered through the FSAs is almost 50 per cent lower than the price of coal as determined through e-auctions. Out of a total of 48 power units that CIL needs to supply fuel to, only 27 units have signed this deal. What is preventing these companies from signing such a lucrative FSA? The devil lies in the details, which in this case is the penalty clause and the percentage at which the penalty triggers in.[PAGE BREAK]

Although the presidential directive talked about a penalty clause in case of non-fulfilment of the committed supply, it has remained silent on the amount of penalty to be levied and has left it to the board of CIL to decide the exact amount. The board, as expected, fixed an insignificant 0.01 per cent of the value of the shortfall in coal supply as the penalty. This is sharply in contrast to the prevailing 10-40 per cent penalty, and would be effective only after the initial three years of signing of the pact.

Assuming that the FSAs will cover all the 347 million tonnes (MT) that CIL will supply to the power sector this fiscal (FY13) and an average price of Rs 1450 per tonne for coal that was realised last fiscal (FY12), the total penalty in this case comes to a mere Rs 5 crore even if CIL does not supply a single gram of coal. This works out to be only 0.03 per cent of CIL’s FY12 net profit. Even this little amount is payable after three years and is subject to force majeure provisions that include a breakdown of equipment and nonavailability of spare parts. The penalty  amount and other conditions hardly offer any incentive to CIL to increase or achieve its production targets.

The next bone of contention between the power companies and CIL is the trigger level, which is the minimum amount of coal that CIL needs to supply in order to avoid a penalty. Until last year, the trigger level was 80 per cent, but now, CIL is insisting on a lowered trigger level of 65 per cent. The reason cited is the production constraints that it faces. The company has fixed a production target of around 470 MT for 2012-13, and at this level, it would be able to supply only 65 per cent of the total expected FSAs signed. The other important reason why CIL is not willing to increase its FSA supply is that every MT of coal diverted at FSA prices results in its profits declining by 0.7 per cent.

All these issues are directly impacting the power companies. In fact, the banking sector also stands to be impacted, though indirectly so. Last year, India’s power generation grew by a mere eight per cent as compared to the 15.5 per cent growth in the installed capacity. The lower growth in generation was mainly due to the shortage of fuel supply, and this is being directly reflected in the lower plant load factors (PLF) of coal stations on an aggregate level. In FY12, the PLF declined by 179 basis points on a yearly basis to 73.5 per cent, and this is the third straight year in which we have witnessed a decline in the PLF.

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Going forward too, we do not see the situation improving. According to one study, the shortage of coal in the power sector is going to be as high as 147 MT at the end of FY15 on the assumption that the currently operational plants and the new plants commissioned operate at a PLF of 75 per cent. What this means is that the supply of coal needs to increase at compounded annual growth rate (CAGR) of 11 per cent if the plants need to run at least 75 per cent of the time. Given the history of lower growth of coal supply in India, this looks very unlikely. For the 12 years ending 2012, the total coal production in India has shown an anaemic CAGR of just around five per cent. In such a scenario (lower fuel supply), power generating companies have to look to the international markets to meet their demand for coal.

Given the price differentials of coal in the domestic and international markets and the recent change in taxation on the export of coal from Indonesia, several power projects are likely to see an increase in the cost of generation. This will also lead to under-utilisation of assets and lower returns on equity (ROEs). Moreover, it has been observed that the state electricity boards (SEBs) typically resort to lower purchase of power in case the prices are too high, adding to the stress of the power generating companies.

Widening Gap
Demand And Supply Of Coal Over 2015
2008 2009 2010 2011 2012 2013E 2014E 2015E
Demand
Power 364 374 386 405 422 496 584 659
Other 144 174 195 220 239 259 279 302
Total 507 549 581 625 661 755 863 962
Supply
CIL 375 401 415 425 433 448 469 487
SCCL 42 45 49 47 51 51 51 51
Others 37 45 49 45 45 54 70 91
Domestic 454 490 513 517 529 553 590 630
Gap -53 -59 -68 -108 -133 -202 -273 -332
Source: Kotak Institutional Equities
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This brings us to the other important constituents of the power chain, the SEBs and the banking sector. The poor state of the SEBs today is an open fact. According to an estimate by ICRA, the losses for discoms in the country (before accounting for government subsidy) stood at Rs 80000 crore in FY2012, up from around Rs 63500 crore in FY2010. Even if we take into account the likely subsidy of Rs 43000 crore in FY12, the losses are still huge at Rs 37000 crore. The reason for such a quantum of losses can be attributed to the lack of political will, which prevents the passing of the actual cost of power to the final consumers.

According to an estimate, the distribution companies need to hike the tariffs by 45-60 per cent to break even this year, and they also need to increase the prices continuously. Someone has to bear these losses, and in this case, it is the banks which are financing them. Almost 70 per cent of the accumulated losses of the distribution companies are being financed by public sector banks (PSBs). This is likely to put stress on the asset quality  of banks, which will be reflected in the increase in their non-performing assets (NPAs).

The Indian banking sector’s total advances to the country’s power sector stood at around Rs 3 lakh crore at the end of FY2012, and if we include financing from PFC and REC, this comes to Rs 5 lakh crore. Of this, 47 per cent is borrowed by SEBs, 30 per cent by private sector generation projects, 15 per cent by public sector units and the remaining seven per cent by private sector T&D projects. Loans to SEBs are nothing but the financing of their incremental losses. We believe that going forward, the exposure of banking credit to the power sector is going to increase as the various power projects pursued by power companies will need huge funding. Moreover, the current increase in tariffs by SEBs is not enough to contain their cash losses, and hence, they would need financing from the banks.

NPAs To Increase
Loans From Banks, PFC And REC To The Power Sector, Fiscal Year-End 2012 (Rs Crore)% Of Total Loans
State Electricity Boards (SEBs) 248700 47%
PSUs 81600 15%
Private Sector - Generation Projects 161100 30%
Private Sector - T&D Projects 39500 7%
Total 530900
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From the discussion, it is clear that the signing of FSAs need not be seen in isolation, as the prolonging of the issue will not impact only CIL and the power producers. If not resolved properly, it will hurt the fiscal position of states and the entire banking sector.

We believe that coal production can be increased significantly if the process of allocation of coal blocks is reformed. For example, the government should give all the environmental approvals and regulatory clearances before auctioning the coal blocks. Better machinery should be deployed to extract coal, which will improve productivity. We have China as an example of a country that increased its coal production by 185 million tonnes per annum (mtpa) over 10 years from CY2000-10 as compared to a corresponding increase of just 24 mtpa in the same period by India.

Therefore, it is clear that a lot needs to be done to attract investments and improve on the production of coal in India, as it plays pivotal role in improving the basic infrastructure that is the ‘power’ of the country. We suggest that our readers to stay away from those banks (especially PSBs) that have major exposure to the power sector, as it has the potential of putting the banks’ assets under stress. Power companies that have an aggressive capital structure and depend on imported fuel to run their plants should also be avoided.

Key Points:

  • The board of CIL has fixed an insignificant 0.01 per cent of the value of the shortfall in coal supply as penalty for non-fulfilment of committed supply under the FSAs, which would be effective only after the initial three years of signing of the pact. This hardly offers any incentive to CIL to increase or achieve its production targets.
  • For the 12 years ending 2012, the total coal production in India has shown an anaemic CAGR of just around five per cent. Due to the lower fuel supply, power generating companies have to look to procuring coal at higher rates from the international markets at higher rates.
  • The SEBs and the banking sectors, both of which are allied with the power generation industry, are also bearing the brunt of losses on account of the coal crisis.
  • Investors should stay away from banks (especially PSBs) that have major exposure to the power sector as well as power companies that have an aggressive capital structure and depend on imported fuel to run their plants.

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