Private Disco
India's electricity system, with a total installed generation
capacity of 94,000 MW, is around 11-12% short of being able to meet
peak demand. In addition, experts estimate that in the next decade
India will need an additional installed capacity of about
120,000-150,000 MW.
A substantial portion of the new capacity will have to come from the private sector. But is India well prepared for this challenge? Why has private participation in India's power generation not taken off as expected? What have been the key impediments, and what needs to be achieved in order to turn around the sector and attract substantial private investment in generation?
The key to ensuring a financially sound and self-sustaining power sector is the efficient management of the distribution business, because this is the source of the cash flow needed to sustain generation. A major weakness in the Indian power system has been inefficient management of the distribution business, which needs to be remedied through sector reform and privatization. Some states are already on the reform path, and it is inevitable that many more will follow.
Like many other developing countries, India's distribution sub-sector, owned and managed by the State Electricity Boards (SEBs), is marked by high levels of technical and commercial losses (often ranging between 35% to 55%), inaccurate billing, inefficient collection, and willful non-payments by some large institutional consumers. Assuming a loss level of 50%, and a collection level of 70%, for every Rupee of power generated/ purchased, the SEB collects only 35 paise back (Figure 1).
To meet their operating expenses and keep the existing transmission and distribution system running, the SEBs had been able to raise the industrial and commercial tariffs over time, rather than increasing operating efficiency, and rationalizing the tariff structure by reducing cross-subsidy. By continuing to operate in a financially imprudent manner over the last few decades, the SEBs are now trapped in a vicious cycle of insolvency.
A Power Purchase Agreement (PPA) with such SEBs, without any higher levels of comfort (e.g. creation of escrow accounts, sovereign guarantee/counter-guarantee, etc.) will not enable the independent power producer (IPP) to mobilize the required project financing. Given the poor financial health of most of the SEBs and state governments, their ability to provide a higher level of comforts is critically constrained. Thus, the only viable option is to take appropriate steps to restructure SEBs' finances and improve their operational efficiencies, which would directly provide additional cash infusion into the power system.
Distribution privatization as the way forward
In the overall reform agenda, restructuring and privatization of the distribution companies (?discos?), combined with appropriate incentive regulation, holds the key to the viability of India's power sector. Advantages of distribution privatization are manifold. It will create real incentives to cut commercial and technical losses, thereby mitigating the need for tariff increases, or perhaps even facilitating end-user tariff reduction. Distribution loss reduction could result in substantial cash infusion into the state's ailing power sector. For larger states, cutting down distribution losses by one percentage point would bring substantial lost revenue back to the system1. In the case of Uttar Pradesh, for example, the IFC estimates that every one percentage point of further loss reduction would bring back to the system revenues worth $11-12 million, that is currently lost in the system; so a five percentage point loss reduction per annum in the initial years may very well result in an additional revenue generation of $41-45 million every year, assuming a collection rate of 75%.
Privatization of distribution will also improve efficiency in billing and collection; enhance the reliability of power supply and quality of customer service; enable discos to raise money from capital markets to fund their investment programs, and thereby reduce, if not eliminate, the fiscal burden on the government; and, most importantly, make the reform process much more difficult to reverse than if private investors were not involved. Moreover, once the discos become financially self-sustaining, they could, with appropriate regulation, buy directly from the generators on the strength of their own credit, rather than government guarantees.
So the question is what policies create the right environment for rapid loss reduction? Extensive Latin American as well as the limited East Asian and Indian experience has shown that an aggressive loss reduction program can be implemented in a disco under private ownership and management, leading to an overall low loss level. Figure 2 below illustrates how aggressive loss reduction strategies were successfully implemented by some selected private discos in Latin America. In most of these discos, over 50% of the total loss reduction was achieved in the first three to four years of privatization.
The track record of the private distribution utilities in the Philippines and India is also noteworthy. Meralco registered a loss level of 11.8% in FY98. The loss levels of private Indian discos range from 11.5% in BSES to 22% in Calcutta Electric Supply Company (CESC); Surat Electric (SEC) and Ahmedabad Electric (AEC) account for 14.6% and 18.8%, respectively. Compared with the current loss levels of 35%-55% in most of the SEBs, the private Indian utilities are much more efficient in loss reduction and cash collection. Privatization of the distribution sub-sectors will rescue them from bankruptcy through substantial commercial and technical efficiency improvements achieved through managerial discipline, re-investment and appropriate regulation. Therefore, distribution privatization is currently the way forward.
Distribution privatization: essential steps
Privatization of the distribution business is often a complicated process and, therefore, needs to be planned carefully and executed efficiently. Although some state governments have already initiated actions on this front, to date only Orissa has been able to privatize all its discos. Based on experiences in India and abroad, we emphasize a few key pre-conditions to a successful privatization of distribution business in the Indian context.
1. Unbundling and corporatization
As the first step towards distribution privatization, the SEB needs to be unbundled into separate corporate entities for generation, transmission and distribution. Experience has shown that geographical right-sizing of the discos is essential. It is important to design the discos' areas of operation, providing for a small number of financially attractive business units with an appropriate mix of consumer categories and rural-urban areas, and large enough to attract keen interest from investors for every bid.
2. Appropriate capital structure
The discos must be financially viable capital structures. For ensuring a self-sustaining disco, two industry standards should be met ? (a) after assuming borrowings for capital investment and/or working capital, the debt-equity ratio of the disco should not generally exceed 50:50; and (b) the discos should have a debt service coverage ratio (DSCR) of at least about 1.3. A more leveraged capital structure is likely to result in a potential ?negative net worth? scenario due to the risks of less-than-anticipated rate of loss reduction or cash collection or tariff increase. In unbundled and corporatized discos, the state governments could facilitate an appropriate debt:equity ratio through capitalization,2 which may involve ploughing back some or all of the privatization proceeds of the government in form of pure or quasi equity, convertible sub-debt, or interest-free deposits, as appropriate, and rescheduling of the existing debt passed on to the discos during corporatization. With the right capital structure, the privatized discos would be able to raise debt for working capital and investment program from the capital markets.
3. Audited financial statements
Potential bidders require properly audited financial statements. In the case of SEBs, typically, the audit reports are not current (i.e. finalized within six months after the end of the financial year), and there is a time lag of more than a year. At the time of corporatization, the new discos may not get a firm balance sheet, and the assets and liabilities may need further adjustments as and when the assets are verified and asset register finalized. Proper auditing of the balance sheet, income statement, and cash flow statement by a reputable private sector auditor would go a long way in providing comforts to the potential bidders. Hence, the discos must have at least one such audit report ready before bids are invited for their privatization.
4. Independent loss assessment
An accurate assessment of the technical and commercial distribution losses is a key requirement for cash flow projections and for tariff determination. However, loss levels reported (in the 20%-30% range) by most of the SEBs prior to their unbundling and corporatization have been a gross underestimate of the actual loss levels (35%-50%) revealed by the discos in their tariff filings. This renders tariff determination by the Regulator extremely difficult and erroneous where tariffs are regulated on a cost-plus basis. Therefore, it is recommended that prior to privatization of any disco, the government commission an independent loss assessment study by a reliable, third-party technical auditor; its report should be supervised/discussed, commented and accepted by the Regulator. This would peg the distribution loss at a level accepted by the Regulator, provide greater confidence to the investors, and would likely lead to higher bids for the distribution assets.
5. Proper risk sharing
A fair and equitable risk sharing structure among the various stakeholders ? the government, the SEB, the public sector power suppliers, the existing lenders, and the discos ? should be put in place prior to the discos' privatization. This is critical to the private operator's ability to turn around the company in the initial years. As the operator of the company, the sponsor-operator must assume the performance risks, namely for achieving the agreed targets for loss reduction, billing and collection, and service standards, and should be incentivized/penalized for over/under performance. On the other hand, the government and the SEB should assume such risks which they are best positioned to mitigate. For example, the government can plough back the privatization proceeds into the disco's equity, reschedule or write-off the existing government debt, as needed, or even convert a portion of the debt into equity to ensure the appropriate debt:equity and debt service coverage ratios for the disco. The public sector power supplier (which in most cases is the SEB or its successor transmission company) might be required to allow a few months receivables from the disco on a rolling basis until some agreed financial standards are achieved. It may also be necessary for the other lenders (mostly public financial institutions) to suitably restructure/reschedule/swap debt for equity/write-off the existing loans, as needed, to help the privatized disco start with a sound balance sheet.
6. Mitigation of some regulatory risks
Key regulatory risks should be mitigated before the disco is put up for bid. First, there must be established a clear, transparent tariff-setting and adjustment mechanism to which the Regulator must adhere. This tariff must be commensurate with satisfactory customer service and the disco's financial viability. Moreover, the regulatory commission must comprise members with relevant experience in energy, finance and law, and excellent reputation. The presence of a well-staffed and well-qualified commission will go a long way in raising the comfort level of the bidders.
In a regulated utility business, other key items requiring a clear understanding among the Regulator, the investor and the consumers include the level of initial losses, the anticipated rate of loss reduction, network expansion and connection program, and service reliability standards. There are different regulatory approaches for achieving this understanding. Main differences relate to how much of this is decided in contracts, how much in law or regulations, how much these decisions are negotiated, and the methods of regulatory supervision and recourse. Common to all approaches, these issues should be determined at the front of privatization process and all the conditions should be transparent so that investors and consumers know exactly what are the ?rules of the game? before it begins. This inspires confidence and enhances sustainability.
In the Indian context, prior to privatization, the Regulator should fix the system loss level, and clearly spell out its expectations on the disco's service standards and expected loss reduction and cash collection profiles. In view of the consumers' willingness and ability to pay, and in order to avoid successive annual tariff hikes, the Regulator should put in place a long term plan with a multi-year (about 5 years) tariff and investment program, with appropriate incentives and penalties, so that the private investors should be able to recover their initial years' losses and earn the necessary rate of return provided the disco achieves the agreed performance targets.
The multi-year capital investment program should aim at distribution loss reduction, system upgradation and expansion. This will provide a great deal of transparency, certainty and predictability to the tariff setting process, and mitigate some of the major regulatory concerns of the potential bidders. Hence, it is recommended that discos enter the bidding stage only after obtaining at least one tariff order from the Regulator incorporating its views and expectations on the above issues.
7. Escrows for the IPPs
Finally, the SEBs should desist from providing escrow cover to the future IPPs before privatization of the discos. It is clear that given the poor financial condition of the SEBs, their escrow capability is severely limited. Any additional escrows would only lower the value of the discos. So the SEBs should not sign costly generation PPAs which have the potential to become stranded costs in a more competitive post-privatization period. Once the discos start operating under private ownership and control, the IPPs would enter into PPAs with discos on strictly commercial terms.
In conclusion, the key priority facing the power sector in India is for the states to focus on privatizing distribution. Once this is successfully implemented, and the discos start operating as profitable commercial entities, addition of new generating capacity through private sector projects will follow inevitably. n
Note:
The views expressed in this article are those of the authors in their individual capacities, and in no way shall be attributed to the IFC. The authors would like to thank Tonci Bakovic and Mark Segal of IFC for their valuable inputs to this article.
About the Authors:
Vivek V. Talvadkar, Director, and Binoy R. Mishra,
Investment Officer
Power Department, International Finance Corporation (IFC)
The World Bank Group
2121 Pennsylvania Avenue, NW,
Washington, D.C. 20433, USA.
Tel: (202) 473-0607 and (202) 458-0393
E-mail: vtalvadkar@ifc.org and bmishra@ifc.org
1. According to the Planning Commission of India, reduction of each 1% in t&d losses would generate an additional revenue of about INRs 5.9 billion at the 1995-96 average tariff. This saving is equivalent to US$177 million (using FY95-96 FX rate of US$1=INRs 33.43) and US$128 million (at the current FX rate of US$1=INRs 46). In short, distribution loss reduction presents a huge potential for efficiency gains in the near term. (See Planning Commission, Ninth Five Year Plan, vol. II.)
2. The ?capitalization programs? of the governments of Bolivia (for generation companies) and Colombia (for both generation and distribution companies) are relevant cases in point. Instead of ?privatization? of the discos, that gave governments the right to appropriate the privatization proceeds immediately upon the change of ownership, the governments ?capitalized? the discos by issuing additional shares to the new private owner. This approach thus loaded up the equity and resulted in a favorable capital structure for the discos, and therefore deserves to be replicated in those Indian states with a low equity base for the discos.
A substantial portion of the new capacity will have to come from the private sector. But is India well prepared for this challenge? Why has private participation in India's power generation not taken off as expected? What have been the key impediments, and what needs to be achieved in order to turn around the sector and attract substantial private investment in generation?
The key to ensuring a financially sound and self-sustaining power sector is the efficient management of the distribution business, because this is the source of the cash flow needed to sustain generation. A major weakness in the Indian power system has been inefficient management of the distribution business, which needs to be remedied through sector reform and privatization. Some states are already on the reform path, and it is inevitable that many more will follow.
Like many other developing countries, India's distribution sub-sector, owned and managed by the State Electricity Boards (SEBs), is marked by high levels of technical and commercial losses (often ranging between 35% to 55%), inaccurate billing, inefficient collection, and willful non-payments by some large institutional consumers. Assuming a loss level of 50%, and a collection level of 70%, for every Rupee of power generated/ purchased, the SEB collects only 35 paise back (Figure 1).
To meet their operating expenses and keep the existing transmission and distribution system running, the SEBs had been able to raise the industrial and commercial tariffs over time, rather than increasing operating efficiency, and rationalizing the tariff structure by reducing cross-subsidy. By continuing to operate in a financially imprudent manner over the last few decades, the SEBs are now trapped in a vicious cycle of insolvency.
A Power Purchase Agreement (PPA) with such SEBs, without any higher levels of comfort (e.g. creation of escrow accounts, sovereign guarantee/counter-guarantee, etc.) will not enable the independent power producer (IPP) to mobilize the required project financing. Given the poor financial health of most of the SEBs and state governments, their ability to provide a higher level of comforts is critically constrained. Thus, the only viable option is to take appropriate steps to restructure SEBs' finances and improve their operational efficiencies, which would directly provide additional cash infusion into the power system.
Distribution privatization as the way forward
In the overall reform agenda, restructuring and privatization of the distribution companies (?discos?), combined with appropriate incentive regulation, holds the key to the viability of India's power sector. Advantages of distribution privatization are manifold. It will create real incentives to cut commercial and technical losses, thereby mitigating the need for tariff increases, or perhaps even facilitating end-user tariff reduction. Distribution loss reduction could result in substantial cash infusion into the state's ailing power sector. For larger states, cutting down distribution losses by one percentage point would bring substantial lost revenue back to the system1. In the case of Uttar Pradesh, for example, the IFC estimates that every one percentage point of further loss reduction would bring back to the system revenues worth $11-12 million, that is currently lost in the system; so a five percentage point loss reduction per annum in the initial years may very well result in an additional revenue generation of $41-45 million every year, assuming a collection rate of 75%.
Privatization of distribution will also improve efficiency in billing and collection; enhance the reliability of power supply and quality of customer service; enable discos to raise money from capital markets to fund their investment programs, and thereby reduce, if not eliminate, the fiscal burden on the government; and, most importantly, make the reform process much more difficult to reverse than if private investors were not involved. Moreover, once the discos become financially self-sustaining, they could, with appropriate regulation, buy directly from the generators on the strength of their own credit, rather than government guarantees.
So the question is what policies create the right environment for rapid loss reduction? Extensive Latin American as well as the limited East Asian and Indian experience has shown that an aggressive loss reduction program can be implemented in a disco under private ownership and management, leading to an overall low loss level. Figure 2 below illustrates how aggressive loss reduction strategies were successfully implemented by some selected private discos in Latin America. In most of these discos, over 50% of the total loss reduction was achieved in the first three to four years of privatization.
The track record of the private distribution utilities in the Philippines and India is also noteworthy. Meralco registered a loss level of 11.8% in FY98. The loss levels of private Indian discos range from 11.5% in BSES to 22% in Calcutta Electric Supply Company (CESC); Surat Electric (SEC) and Ahmedabad Electric (AEC) account for 14.6% and 18.8%, respectively. Compared with the current loss levels of 35%-55% in most of the SEBs, the private Indian utilities are much more efficient in loss reduction and cash collection. Privatization of the distribution sub-sectors will rescue them from bankruptcy through substantial commercial and technical efficiency improvements achieved through managerial discipline, re-investment and appropriate regulation. Therefore, distribution privatization is currently the way forward.
Distribution privatization: essential steps
Privatization of the distribution business is often a complicated process and, therefore, needs to be planned carefully and executed efficiently. Although some state governments have already initiated actions on this front, to date only Orissa has been able to privatize all its discos. Based on experiences in India and abroad, we emphasize a few key pre-conditions to a successful privatization of distribution business in the Indian context.
1. Unbundling and corporatization
As the first step towards distribution privatization, the SEB needs to be unbundled into separate corporate entities for generation, transmission and distribution. Experience has shown that geographical right-sizing of the discos is essential. It is important to design the discos' areas of operation, providing for a small number of financially attractive business units with an appropriate mix of consumer categories and rural-urban areas, and large enough to attract keen interest from investors for every bid.
2. Appropriate capital structure
The discos must be financially viable capital structures. For ensuring a self-sustaining disco, two industry standards should be met ? (a) after assuming borrowings for capital investment and/or working capital, the debt-equity ratio of the disco should not generally exceed 50:50; and (b) the discos should have a debt service coverage ratio (DSCR) of at least about 1.3. A more leveraged capital structure is likely to result in a potential ?negative net worth? scenario due to the risks of less-than-anticipated rate of loss reduction or cash collection or tariff increase. In unbundled and corporatized discos, the state governments could facilitate an appropriate debt:equity ratio through capitalization,2 which may involve ploughing back some or all of the privatization proceeds of the government in form of pure or quasi equity, convertible sub-debt, or interest-free deposits, as appropriate, and rescheduling of the existing debt passed on to the discos during corporatization. With the right capital structure, the privatized discos would be able to raise debt for working capital and investment program from the capital markets.
3. Audited financial statements
Potential bidders require properly audited financial statements. In the case of SEBs, typically, the audit reports are not current (i.e. finalized within six months after the end of the financial year), and there is a time lag of more than a year. At the time of corporatization, the new discos may not get a firm balance sheet, and the assets and liabilities may need further adjustments as and when the assets are verified and asset register finalized. Proper auditing of the balance sheet, income statement, and cash flow statement by a reputable private sector auditor would go a long way in providing comforts to the potential bidders. Hence, the discos must have at least one such audit report ready before bids are invited for their privatization.
4. Independent loss assessment
An accurate assessment of the technical and commercial distribution losses is a key requirement for cash flow projections and for tariff determination. However, loss levels reported (in the 20%-30% range) by most of the SEBs prior to their unbundling and corporatization have been a gross underestimate of the actual loss levels (35%-50%) revealed by the discos in their tariff filings. This renders tariff determination by the Regulator extremely difficult and erroneous where tariffs are regulated on a cost-plus basis. Therefore, it is recommended that prior to privatization of any disco, the government commission an independent loss assessment study by a reliable, third-party technical auditor; its report should be supervised/discussed, commented and accepted by the Regulator. This would peg the distribution loss at a level accepted by the Regulator, provide greater confidence to the investors, and would likely lead to higher bids for the distribution assets.
5. Proper risk sharing
A fair and equitable risk sharing structure among the various stakeholders ? the government, the SEB, the public sector power suppliers, the existing lenders, and the discos ? should be put in place prior to the discos' privatization. This is critical to the private operator's ability to turn around the company in the initial years. As the operator of the company, the sponsor-operator must assume the performance risks, namely for achieving the agreed targets for loss reduction, billing and collection, and service standards, and should be incentivized/penalized for over/under performance. On the other hand, the government and the SEB should assume such risks which they are best positioned to mitigate. For example, the government can plough back the privatization proceeds into the disco's equity, reschedule or write-off the existing government debt, as needed, or even convert a portion of the debt into equity to ensure the appropriate debt:equity and debt service coverage ratios for the disco. The public sector power supplier (which in most cases is the SEB or its successor transmission company) might be required to allow a few months receivables from the disco on a rolling basis until some agreed financial standards are achieved. It may also be necessary for the other lenders (mostly public financial institutions) to suitably restructure/reschedule/swap debt for equity/write-off the existing loans, as needed, to help the privatized disco start with a sound balance sheet.
6. Mitigation of some regulatory risks
Key regulatory risks should be mitigated before the disco is put up for bid. First, there must be established a clear, transparent tariff-setting and adjustment mechanism to which the Regulator must adhere. This tariff must be commensurate with satisfactory customer service and the disco's financial viability. Moreover, the regulatory commission must comprise members with relevant experience in energy, finance and law, and excellent reputation. The presence of a well-staffed and well-qualified commission will go a long way in raising the comfort level of the bidders.
In a regulated utility business, other key items requiring a clear understanding among the Regulator, the investor and the consumers include the level of initial losses, the anticipated rate of loss reduction, network expansion and connection program, and service reliability standards. There are different regulatory approaches for achieving this understanding. Main differences relate to how much of this is decided in contracts, how much in law or regulations, how much these decisions are negotiated, and the methods of regulatory supervision and recourse. Common to all approaches, these issues should be determined at the front of privatization process and all the conditions should be transparent so that investors and consumers know exactly what are the ?rules of the game? before it begins. This inspires confidence and enhances sustainability.
In the Indian context, prior to privatization, the Regulator should fix the system loss level, and clearly spell out its expectations on the disco's service standards and expected loss reduction and cash collection profiles. In view of the consumers' willingness and ability to pay, and in order to avoid successive annual tariff hikes, the Regulator should put in place a long term plan with a multi-year (about 5 years) tariff and investment program, with appropriate incentives and penalties, so that the private investors should be able to recover their initial years' losses and earn the necessary rate of return provided the disco achieves the agreed performance targets.
The multi-year capital investment program should aim at distribution loss reduction, system upgradation and expansion. This will provide a great deal of transparency, certainty and predictability to the tariff setting process, and mitigate some of the major regulatory concerns of the potential bidders. Hence, it is recommended that discos enter the bidding stage only after obtaining at least one tariff order from the Regulator incorporating its views and expectations on the above issues.
7. Escrows for the IPPs
Finally, the SEBs should desist from providing escrow cover to the future IPPs before privatization of the discos. It is clear that given the poor financial condition of the SEBs, their escrow capability is severely limited. Any additional escrows would only lower the value of the discos. So the SEBs should not sign costly generation PPAs which have the potential to become stranded costs in a more competitive post-privatization period. Once the discos start operating under private ownership and control, the IPPs would enter into PPAs with discos on strictly commercial terms.
In conclusion, the key priority facing the power sector in India is for the states to focus on privatizing distribution. Once this is successfully implemented, and the discos start operating as profitable commercial entities, addition of new generating capacity through private sector projects will follow inevitably. n
Note:
The views expressed in this article are those of the authors in their individual capacities, and in no way shall be attributed to the IFC. The authors would like to thank Tonci Bakovic and Mark Segal of IFC for their valuable inputs to this article.
About the Authors:
Vivek V. Talvadkar, Director, and Binoy R. Mishra,
Investment Officer
Power Department, International Finance Corporation (IFC)
The World Bank Group
2121 Pennsylvania Avenue, NW,
Washington, D.C. 20433, USA.
Tel: (202) 473-0607 and (202) 458-0393
E-mail: vtalvadkar@ifc.org and bmishra@ifc.org
1. According to the Planning Commission of India, reduction of each 1% in t&d losses would generate an additional revenue of about INRs 5.9 billion at the 1995-96 average tariff. This saving is equivalent to US$177 million (using FY95-96 FX rate of US$1=INRs 33.43) and US$128 million (at the current FX rate of US$1=INRs 46). In short, distribution loss reduction presents a huge potential for efficiency gains in the near term. (See Planning Commission, Ninth Five Year Plan, vol. II.)
2. The ?capitalization programs? of the governments of Bolivia (for generation companies) and Colombia (for both generation and distribution companies) are relevant cases in point. Instead of ?privatization? of the discos, that gave governments the right to appropriate the privatization proceeds immediately upon the change of ownership, the governments ?capitalized? the discos by issuing additional shares to the new private owner. This approach thus loaded up the equity and resulted in a favorable capital structure for the discos, and therefore deserves to be replicated in those Indian states with a low equity base for the discos.
Request a Demo
Interested in IJGlobal? Request a demo to discuss a trial with a member of our team. Talk to the team to explore the value of our asset and transaction databases, our market-leading news, league tables and much more.