Coal Indias fuel supply agreements - a solution to Indias power crisis?

Overview

Indias power sector has been witnessing challenges in recent times, with the countrys power deficit at around 8.5 percent. The demand for electricity is continuously growing, driven by high economic growth and increased rural electrification; however, supply is unable to keep pace with demand primarily due to a fuel shortage. Currently, more than 50 percent of Indias installed generation capacity is coal-based. Over the last five years, the demand for coal has been growing at an average rate of 89 percent annually as compared to a 56 percent increase in domestic production. This has widened the demandsupply gap, leading to growing dependence on imported coal. In 2011 12, the country imported around 100 million tons of coal (including thermal and coking coal) .

The shortage of coal is not only affecting operational plants but is also raising concerns around the viability the viability of future power projects. The lack of coal linkages is making it incrementally difficult for power-generation companies to raise capital for their proposed thermal plants. Further, as per recent reports, the Government of India is likely to lower the countrys power capacity addition target for the Twelfth Five Year Plan from 1,00,000 MW to 75,000 MW as a result of fuel shortage.

Fuel supply agreement: key terms and challenges associated with implementation

To ensure fuel security to coal-based power producers, the Indian Government issued a presidential directive to CIL in April 2012, asking it to sign fuel supply agreements (FSAs) with power companies. The following are the key characteristics of FSAs, proposed by the CIL:

Criteria: FSAs will be signed with power plants that have entered longterm power purchase agreements (PPAs) with distribution companies, commissioned between April 2009 and December 2011. In the next round, CIL will sign FSAs with those plants scheduled to be commissioned by 31 March 2015.

Duration: The FSAs will be signed for a period of 20 years and will be reviewed after every five years. Commitment and penalties: The FSAs will be signed with 80 percent of assured contracted quantity (ACQ) of the committed coal supply. In the event of supply falling short of 80 percent, CIL has to pay a penalty at 0.01 percent of the value of the shortfall quantity. Further, this penalty clause is said to be applicable only after three years of signing the contract; this means that for the first three years, CIL will not be obliged to supply the contracted quantity. Coal imports: If CIL cannot meet demand through domestic supplies, it can meet the shortfall through imported coal. If the buyer agrees to accept the imported coal, CIL will import coal for power companies and supply it at the unload port on a cost-plus basis, including service charges. Thus, CIL would not be responsible for the transportation of imported coal from the port to the project site. Additionally, if a customer does not accept imported coal, CIL would not be liable to pay any penalties. Force majeure clause: The new FSAs - along with existing force majeure events such as natural calamities, strikes and mine fires - includes additional force majeure circumstances to cover the risks arising from third parties. Additional conditions include the global shortage of imported coal, lack of response to enquiries, the breakdown of equipment, delays by contractors, power shortages, and obstruction in the transportation of coal, from pithead to sidings, by agitations/mob-violence/riots.

Power plants covered under the new FSA are expected to be at a disadvantage over plants that are supplied coal as per existing FSA. Many power-generation companies have raised concerns over the terms of the new FSA and are not willing to sign the contract with CIL. As on 18 June 2012, only 27 of all planned 48 thermal power units have entered the long-term fuel supply agreement. Power producers are opposing the new FSA due to the following reasons:

In the new FSA, the penalty rate is very low (0.01 percent as against 10 40 percent in the existing FSA). Therefore, it may be possible that CIL, instead of meeting demand requirements, prefers to pay penalty. In the case of partial supplies from CIL, power producers have to either operate at a relatively low plant load factor (PLF) or use expensive imported coal. At current international coal prices, the cost of power generation from imported coal (assuming a 70:30 mix between domestic and imported coal) is around 40 percent higher than a plant solely based on domestic coal.

The addition of new force majeure conditions would allow CIL easy exit options from the agreement.

Government intervention to resolve the issue between CIL and power companies

To strike a middle ground between CIL and power companies, the Prime Minister Office (PMO) has intervened and suggested a revision to CILs new FSA to address the concerns of all stakeholders.

Commitments: The Government concurs with CILs demand and agrees to lower fuel supply commitment of 65 percent for first three years as against 80 percent prescribed earlier. Further, in the fourth year, the supply has to increase to 72 percent followed by 80 percent in the fifth year of the agreements. Penalties: The Government also proposed an increase in penalty, from 0.01 percent to 20-40 percent, depending on the level of supply shortfall below the level agreed upon (65 percent). Other clauses: The PMO has also asked CIL to remove the three-year moratorium on penalty, review the force-majeure clauses, and modify clause terms that allow CIL to review and amend delivery levels every five years.

The proposed changes are acceptable to some power producers, and the NTPC has agreed to sign FSA with the revised terms. However, the Ministry of Power is not willing to accept the 65 percent commitment level and has said that banks are not accepting the 65 percent trigger level as against the earlier directive of 80 percent supply assurance. The CIL board is yet to take a final decision on the revised terms of the FSA.

Analysis

The presidential directive to CIL is a small step forward towards the resolution of the countrys fuel problem. However, this step alone cannot plug the gaps, as aggregate demand from all proposed FSAs and letter of assurance (LoAs) is likely to exceed the CILs current and near-future coal production. By 2015, CIL is

expected to see a shortfall of around 80 million tonnes, thus limiting CILs ability to meet growing demand. Further, to bridge this gap, the PMO has suggested that CIL reduces its e-auction quantity and divert e-auction coal to the power sector. While this measure will likely help increase coal supply to the power sector, it may be regressive step as it will adversely affect small coal consumers and CILs profitability.

The following measures could help resolve Indias coal shortage:

Build CILs coal import capability: CIL is primarily a producer and has little experience in importing large quantities of coal. Yet, given the growing dependence on imported coal, CIL need to build its import capabilities. Initially, CIL could import coal with the help of the MMTC and STC and gradually develop the capability and infrastructure (logistics) to import large volumes of coal. To increase imported coal acceptability, CIL could consider the pricepooling of imported coal with domestic coal and supply coal to power companies at an average price. This could help lower the cost disparity among power producers. However, for this mechanism to be efficient, the pooled price should be available to only those power plants that have coal linkages with CIL and are not based on imported coal.

Increase power tariffs to make imported coal affordable: There is a need to increase power tariffs for the end consumer to make imported coal-based power plants economically viable. Further, the government should address the issues of power plants that are stuck with low price PPAs and their fuel cost has increased considerably due to regulatory changes in coal exporting countries such as Indonesia and Australia. To protect these developers, the government could allow at least a partial pass-through' of fuel costs for projects awarded under tariff-based competitive bidding. This would increase end-consumer prices but help in avoiding stranded capacities and is necessary to retain private players interest in the power sector. Enhance domestic coal production: To increase productivity from existing fields, it is important to deploy the latest technology and professional assistance. Further, there is need to accelerate the process of land acquisition and environmental clearances, to increase the total area under exploration. Further, the government could adapt the NELP model (used for oil and gas blocks bidding) and allow global mining majors to participate instead of limiting the bidding to only end users (such as steel, cement and power plants).This route, along with much needed investment, can be expected to bring global technology and capabilities to the Indian mining sector.

Thus, to resolve the power crisis, the government should take a holistic approach - considering the interest of various stakeholders, eliminating roadblocks to increased domestic coal production and allowing generation companies to pass high-fuel costs on to end consumers.

Source: www.kpmg.com