Shares of NTPC Ltd and Power Grid Corp. of India Ltd gained 1.7% and 3.7% on Monday after the sector regulator proposed continuation of current incentives. In a positive surprise, the draft note from the Central Electricity Regulatory Commission (CERC) suggests continuation of the 15.5% regulated return on equity (RoE) for generation and transmission companies.

The regulated RoE has been maintained despite a noticeable reduction in interest rates. Tariff regulations are set every five years. When they were announced in early 2014, the benchmark 10-year government bond yield was at 8.8%. It’s now at 7.4%. Tracking this, most analysts were pencilling a cut in RoE. Despite the rise in bond yields in the past year, nobody was expecting continuation of the RoE at the current level.

With more than 90% of Power Grid’s profits driven by the regulated RoE, it benefits the most, said analysts at Motilal Oswal Securities Ltd. Once commissioned, transmission projects have limited operating risks. So yield and profitability is more intertwined to finance costs and the regulated rate of return. So, while their interest costs have fallen, stable returns means margins will increase.

The scenario is slightly different for NTPC. Apart from the regulated RoE, utilization levels, operating efficiency and scope of cost recovery also influence NTPC’s earnings. Here, the regulator proposed tighter norms for fixed cost recovery on parameters such as fuel inventories and working capital finance cost.

On the other hand, the regulator did propose relief on the loss of the calorific value of coal during storage. Consequently, NTPC’s earnings are estimated to see only an incremental rise. “Our earnings per share estimates could rise 1% for FY20E-21E if this draft is finalized," analysts at Jefferies India Pvt. Ltd said in a note on NTPC.

Even so, continuation of the current RoE and the lack of major earnings dilutive measures bring relief for investors. The last tariff regulation changed the basis for incentive calculation from plant availability to utilization levels, making a significant dent to NTPC’s earnings. From this perspective, the proposals are less detrimental and remove a major overhang for the stocks.

But they alone cannot aid the stocks for long. As earnings lagged estimates, the stocks underperformed the benchmark index Nifty over the past year. The key reasons for the underperformance persist, with NTPC continuing to face fuel constraints. The outlook for Power Grid is weighed down by reducing opportunities in the transmission & distribution segment. The promise of stable RoE notwithstanding, what is crucial is how these companies overcome these challenges.