The power sector is expected to be heading towards a consolidation phase. Companies with strong balance sheets shall acquire the weaker players who venture into the sector without the requisite experience for operating a power plant. These weaker players would also like to exit the sector given their small balance sheet size and the mounting pressure from banks to repay the debt, avers Saurabh Mukherjea and Bhargav Buddhadey. The mismanagement of balance sheets across the power, infrastructure and construction sectors has been such that it has led to Moody placing a negative outlook upon the Indian banking system. Moody's has cited the deteriorating asset quality as one of the key reasons for its negative outlook. The power, infrastructure and construction sectors put together accounted for 14 per cent of NPAs in Indian banks and 20 per cent of assets under the corporate debt restructuring as on September 2012. This is despite these sectors constituting only 16 per cent of banks' outstanding credit as on November 2012. Balance sheet discipline is the key to success in the power sector, given the sector's capital-intensive nature (capex of Rs 5 crore for 1MW capacity), long gestation period (36-48 months) to commission a power plant, long repayment cycle (typical tenure for repayment of loan is 10-12 years) and likely execution delays (given the need to get about 65 clearances to set up a thermal power project). Thus, until 2005, the Central Electricity Regulatory Commission (CERC) allowed tariff bidding based only on regulated return on equity (RoE), wherein the RoE was guaranteed with fuel costs being a pass-through expense. However, the National Tariff Policy (in 2005) introduced tariff guidelines based on competitive bidding, wherein the bidding was done on a tender basis and RoEs were not regulated. This was meant to encourage private sector participation and competition. Private sector participation in plan-wise capacity addition increased significantly in the 11th Plan (2007-12) (refer to the exhibit below) and consequently the order book for India's biggest Boiler Turbine-Generator (BTG) company, BHEL also swelled (refer to Exhibit 2). However, the experience of the private sector has been less than ideal so far. Net debt: equity for the eight largest Independent Power Producers (IPPs) as on FY12 stood at an alarming 2.0x compared with 0.6x for NTPC (a well entrenched public sector utility). Even the largest of India's private sector entities, such as Tata Power and the Adani Group, (both well-known conglomerates) are pleading before the CERC for an increase in tariff for their respective Mundra projects in Gujarat. These projects are currently reeling under losses, because their negotiated contracts with miners in Indonesia were reneged owing to regulatory changes in that country. In addition, about 64 GW of capacity has been stalled (primarily dominated by the private sector), owing to issues in land acquisition, availability of coal, environment clearances, etc. Although, this dismal fate of the private sector can be blamed on issues around non-availability of coal and delays in obtaining regulatory clearances, a major challenge has been over-aggression and sheer inexperience on the part of many of these IPPs. Many IPPs went overboard and planned to commission projects with capacities ranging between 5GW-10GW in a span of three years without having achieved any critical mass or in some cases without any operational capacity on the ground. Surprisingly, they were successful in raising capital from both the equity and debt markets with ease as back in FY10 Power & Construction IPOs were oversubscribed many times over. The power sector dominated the primary market issuance in FY10 with a 44 per cent share compared with 15.8 per cent in FY08 and 5.9 per cent in FY09. Also, banks' loan growth during November 2008 to November 2012 grew at a CAGR of 16.6 per cent which was supported by the power sector, given that the share of loan outstanding to the sector doubled from 4.3per cent as on 30 November 2008 to 8.3 per cent as on 30 November 2012. Thus we believe that consolidation is likely to happen in the power sector. Companies with strong balance sheets shall acquire the weaker players who ventured into the sector (without any experience of operating a power plant) chasing valuations (the P/B of the sector in FY08-10 had reached ~3x vs. 1.5x-2.5x now). These weaker players now want to exit the sector given their small balance sheet size and mounting pressure from banks to repay the debt drawn for the power projects that have stalled. This consolidation augurs well for the sector, because only serious and experienced players with strong balance sheets are likely to survive. The trend that persisted during FY08-10 of players bidding aggressively in the wake of out-winning each other is likely to be relegated to the past. Signs of pricing power returning to the sector are already visible, with the recent bids for Uttar Pradesh's 1.5GW power project and Andhra Pradesh's 500MW power project coming in at Rs 4.48 and Rs4.29 per unit, respectively, which is higher by at least 50per cent than the bids made three years ago. Another encouraging trend is tariffs being increased by state electricity boards (SEBs). At least 19 SEBs announced a much-needed tariff increase in the range of 5-37per cent. Consequently, the gap between the cost of procurement of power and revenue is likely to decline from 75paise in FY12 to 58paise in FY13. Several steps have been taken to address the above challenges, such as clearance of the Land Acquisition Bill and the formation of a Cabinet Committee on Infrastructure (which will address the issues in land acquisition and environment clearances, respectively). Also, coal price pooling is being contemplated upon to address fuel availability issues. Consequently, we are advising investors to play the power sector by investing in IPPs. Also, we believe the revival of IPPs is critical for the revival of related sectors such as electrical equipment manufacturers (like BHEL), transmission and distribution companies (like Crompton Greaves, Power Grid, and Kalpataru Power) and 'balance of plant' companies (like BGR and Elecon Engineering). If the IPPs are not revived soon investors might want to reduce their holdings in large Indian banks. With the power sector accounting for ~8.3per cent of the banks' system-wide credit as on November 2012 and with ~29GW equivalent of power projects slated to come up for commissioning in FY14 and FY15, Indian banks are highly exposed if the power sector does not get out of this connundrum.
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