Should Tata Power and Adani be rewarded for blunders? The follies of mispricing risk

The Central Electricity Regulatory Commission’s (CERC’s) recent orders - one on compensating Tata Power and Adani Power for higher fuel costs, and the other on tightening tariff guidelines for all power companies - is indicative of the sheer complexity of the energy pricing regime we have put in place. The same problems afflict other sectors such as gas and fertiliser, where too government and regulators play a role in pricing and investment decisions, creating endless friction and controversy due to the in-built scope for doctoring numbers.

In power, electricity producers are guaranteed a 16 percent return on equity - including 0.5 percent for early completion of projects. In fertiliser , the policy assures a 12 percent return on equity for urea plants. Equity, in both cases, is not just share capital, but shareholders’ funds employed in the business.

In gas, where contracts under the New Exploration and Licensing policy (NELP) of the early 2000s were awarded on the basis of competitive bidding (with the offered share of profit oil to the government being a key weighted factor), the government is not supposed to guarantee any price or return, but a “market-based” price discovered at “arm’s length”. The reason why government has to “approve” prices is to ensure that there is no transfer pricing or deliberate distortion that results in lower royalty or taxes.

But in all cases, it is obvious that the contracts signed so far are not foolproof, leaving scope for differences and possible fraud and misrepresentation of facts.

Let’s take the CERC decision to give a higher compensatory tariff to Tata Power and Adani projects in Mundra , both of which were based on imported coal from Indonesia. Since the Indonesian government imposed an unexpected tax on coal in 2011, import costs shot up and both power plants went into losses.

Two issues arise from this: when the projects were awarded on the basis of tariff-based bidding, how is it that the two companies signed power purchase agreements (PPAs) on the assumption that the price of their prime raw material - coal - won’t change? Doesn’t this indicate a very poor understanding of business risks by the companies involved?

The second point relates to commonsense: when fixed-price PPAs are signed with power suppliers, shouldn’t the distribution companies (discoms), who buy the power, and the regulator not have asked basic questions about how increases in fuel prices will be handled, before okaying the contract? This is what regulators are supposed to do. So, at the very least, the regulators have failed in this case. In case the regulator took the line that power producers have to deliver as per contract, then they should have asked for bank guarantees - so that businessmen know they can’t wriggle out of commitments made.

Thus the most important issue is simple: a contract is a contract, right or wrong. If Tata Power and Adani Power have signed foolish PPAs which ignored country and policy risks, they should pay the price for it. While it is no one’s case that the plants must be shut down (tariffs have to be raised to keep them running), at the very least the two power producers should not be rewarded for their foolishness: this means either their returns should be cut down from what is statutorily promised, or their equity must be pared to reflect the regulatory bailout. This is the most sensible course, now that we have been presented with a fait accompli.

The other CERC order involves changing the return goalposts for the next five years. This impacts the public sector National Thermal Power Corporation (NTPC) the most. The key elements of the new guidelines are that incentives for performance will be based not on plant availability, but plant load factor (PLF). That is, the basis for incentivisation is being shifted from supply of power to demand for power. Earlier, the incentives depended on ensuring that 85 percent of capacity is available to the grid. This is down to 83 percent from 85 percent, and the incentives to be paid out will depend not even on this figure, but how much electricity is actually sold to the grid (i.e. PLF).

The reason why this is being done is perverse: the power discoms are unable to pay and hence have curtailed their power purchases, even if it means power cuts in some areas. If incentives were based on plant availability rather than PLF, tariffs would be higher - causing more distress to power buyers.

Once again the regulatory issues are obvious: if the returns to NTPC have to be curtailed because discoms can’t pay (they have over Rs 2,00,000 crore in accumulated losses), then should the performer (NTPC) be penalised or the non-performers (discoms)?

The Reliance gas price dispute has some similarities to the Tata and Adani issues. The main reason why people are objecting to the government’s decision to raise gas prices from $4 per mmBtu to $8 from 1 April this year is this: it will raise prices for power and fertiliser units based on the gas, possibly making them unviable.

The parallels are simple: Tata and Adani power tariffs have to be raised because the companies didn’t plan for increases in coal costs; power and fertiliser prices may have to be raised because they assumed that gas prices cannot change - at least not much.

What does this say for the quality of business planning in energy and fertiliser and the competence of the regulatory agencies?

The villain of the piece is clearly government involvement in fixing prices. Here’s why:

One, if government fixes prices, it has to be on some basis. This incentivises companies to game the system. If price is dependent on investment, costs may be padded up or exaggerated. If incentives are based on capacity use or installation, higher capacity use will be shown. Fertiliser plants, which were incentivised to maximise capacity use at one point, often showed 105 percent and 110 percent capacity use to earn more. Or they could have underdeclared capacity installed to show higher utilisation. In power, one cannot be sure that plant availability numbers were not doctored.

Two, when there is no market-based pricing, the public assumes that it is entitled to a free lunch, and that government is batting on its behalf for this meal. This means every time prices are raised, it is seen as collusion with producers. Now that diesel and petrol prices are being adjusted regularly, the public realises - howsoever grudgingly - that this may not be so.

Three, fixed prices lead to mispricing and overconsumption of scarce natural resources. This is what the Coalgate scam is partly about. Why were people given free coal blocks? They were supposed to produce power (or other things) at low prices. This led to aggressive and unrealistic bidding for power projects and low-tariff PPAs - which incentivised successful winners to make money by diverting the coal to other uses.

The Essar gas-based power unit in Gujarat has decided to shift to coal - possibly at a huge additional investment cost of Rs 2,500 crore - because imported gas prices have shot through the roof. The original plant was built on the basis of fixed administered pricing. Now that the regime is changing, it makes sense to shift away from gas. If enough businessmen take such decisions, the domestic market price for gas could also fall - but that is another story. The point is business-like decisions have to be made in gas depending on its market prices. Depending on government whims and fancies is simply foolish.

Four, government intervention in pricing also results in wrong business decisions. Should India have set up power and fertiliser plants based on “market-priced” gas - when both power and fertiliser are heavily subsidised? If power and fertiliser are not viable without underpriced domestic gas or other inputs, why set them up at all? Why should gas be used in power, if it can be sold for a higher prices to, say, the ceramic industry or to city gas distribution? It is worth noting that even at $8 per mmBtu, the cost in terms of energy equivalence, would be no more than Rs 350 per household gas cylinder. This is far below the subsidised price of LPG of Rs 414 per cylinder in Delhi - Rs 650 below cost. (Note: LPG is made from propane and butane, while Reliance gas is methane - and not suitable for domestic gas, but this is just to illustrate how much we pay for heat without knowing it. But when we know it we object.)

Five, government intervention may also end up helping producers at the cost of consumers if global prices fall. The argument right now is about whether gas prices should be raised to $8 per mmBtu. But what if a global recession brings prices down, and prices don’t have to be raised - and can even be cut?

Six, handing over sensitive price-sensitive sectors like energy to the public sector is no solution - for this will increase political irresponsibility. Over the last 10 years, the UPA has subsidised petro-products to the tune of over Rs 8,00,000 crore - to the detriment of the public sector. While ONGC, IOC, HPCL and BPCL are biggest losers from price control, Reliance sells its petro-goods abroad at a profit - howsoever thin. In this case, Reliance makes money by using market pricing, while the public sector producers and marketers lose money from having to subsidise the consumer endlessly.

The reality is this: consumers and producers and governments have to accept the reality of markets and market-based pricing. Government interventions, ostensibly designed to help consumers, often lead to perverse results where we either misprice scarce resources and deplete them or end up giving unwarranted gains or losses to consumers or producers or both.

The priorities for the next government are clear: it has to shift all energy products to market-based pricing and transparent and clean contracts that can be enforced. As the Adani, Tata Power and Reliance gas controversies show, the business of government is not to meddle with markets, but to ensure transparent and clean regulation. This is what Arvind Kejriwal, Narendra Modi and Rahul Gandhi should focus on as politicians. Anything else would be irresponsible.