No such thing as a perfect renewable energy contract

The ultimate need for a renewable energy project is low-interest-rate funding seeking modest yields over time

While all power producers face counter-party risk, this is particularly acute for renewable energy. Photo: Bloomberg
While all power producers face counter-party risk, this is particularly acute for renewable energy. Photo: Bloomberg

India’s 175 GW renewable energy (RE) targets by 2022 are ambitious, to say the least. Compared to RE targets in Europe, China, or California that require 4-5% growth in RE capacity annually, Indian targets require 25% growth. This translates to enormous capital investment (well over $100 billion), including from global investors.

RE investors used to complain that dealing with India was like dealing with 30 countries; each state had its own norms. The model bidding document across states took care of that complaint. This is now being supplemented by model power purchase agreements (PPAs), drafts of which have been circulated to stakeholders. While this is a positive step, it ignores a fundamental challenge: A “perfect” contract is only on paper. What happens when things don’t go as planned?

RE is overwhelmingly in the hands of the private sector. Even the Solar Energy Corporation of India Ltd (Seci), NTPC Ltd, and other quasi-governmental RE programmes involve private developers. While all power producers face counter-party (off-taker) risk, i.e., risks from struggling state utilities (distribution companies, or discoms), this challenge is particularly acute for RE, which is volatile and expensive for discoms in the short term, at least on a cash basis.

What happens when utilities don’t buy the power as they promised, despite a PPA? Or, worse, take the power but don’t pay? If states don’t offtake power, can developers easily sell this power to third parties? Due to scheduling and grid reasons, this is neither automatic nor easy. Worse, the prices available may be lower than contracted in the PPA, especially considering the low power exchange (spot) prices in the last few years.

Yet, one doesn’t often hear of developers declaring defaulters, because doing so effectively severs the relationship, leaving few alternatives for the power projects. It also has a negative impact on investor sentiment. Instead, projects muddle along, else risk becoming political or murky, potentially attracting palm-greasing.

What violates a contract?

RE contracts, like most contracts, have fine print. Even the upcoming model contracts have conditions under which a utility may refuse to offtake power, ostensibly under grid security norms. Even if required, all such backing down must be transparent, and ideally declared by an independent system operator (ISO). The affected party should not be the one unilaterally determining when a force majeure (unexpected events that prevent the fulfilment of a contract) equivalent clause applies. Otherwise, we risk a charade similar to how airlines get to absolve themselves of any delays under the guise of “weather”.

The risks of not buying will only increase as RE grows from today’s approximately 6% of power consumed to over 10% in just a few years. Even if the price premium comes down, the operational impacts are non-trivial—RE often helps with energy requirements but not power capacity requirements, since India’s peak power demand is mostly in the evening. Just like Open Access (retail choice) was mandated under the Electricity Act, 2003 but overtly and covertly resisted by utilities (also often under grid security claims), who feared losing their paying customers and disliked the operational and planning headaches, such a “go slow” mentality towards RE by states represents one of the largest risks for scaling up RE.

Transparency is the first requirement

When one doesn’t trust the buyer (or seller), a common mechanism has been the use of escrow accounts. For RE projects, pooled mechanisms such as the Payment Security Mechanism envisaged by Seci—the special purpose vehicle for buying and bundling RE across projects—have limits on the power capacity they can cover. Any amount could, in theory, be covered, but at a cost, which today is being borne by the Central government. Even with an escrow, if drawn down, how is this to be replenished or prevented from becoming a moral hazard?

Instead of focusing on risk management, why not improve risk avoidance? The Clean Energy Finance Forum has suggested improved transparency for utilities as a key need, especially related to RE purchases. In fact, we don’t even have consistent, granular and timely data on RE production. For starters, stakeholders, especially developers, need to know quanta of backing down, along with a reason (if declared). Importantly, we need to have transparent data on payments made to RE (and all) power projects. Delays cannot be swept under the rug, masking under-performing assets that will also never be declared non-performing.

The ultimate need for RE and other infrastructure is “patient capital”, which is low-interest-rate funding seeking modest yields over time, like a home rental, instead of capital willing to take on higher risks but expecting higher returns, like an equity developer interested in asset appreciation or resale. Patient capital is held by sovereign, pension and insurance funds, which seek governance, predictability, and then returns.

The sooner we recognize that improved contracts are necessary but not sufficient, the sooner we can tackle risks not addressed by the contracts, either because they are outside the scope of the contract, or because the contracts only cover the risks in theory but not in practice.

Rahul Tongia is a fellow, Brookings India, and chairs the working group on policy of the Clean Energy Finance Forum.

More From Livemint