Opening the Pandora’s box on tariff-based competitive bids

The Central Electricity Regulatory Commission (CERC) order on compensatory tariffs will have significant implications for competitively bid power projects based on imported sources. Tariff-based competitive bids had been structured such that both capacity and energy (mostly fuel) charges could be determined by the bidders, with an option to keep a portion of these open to escalation for which the formulae were provided by CERC using a diverse basket of domestic and international indices.

add_main_imageThis was done with a view that those bidders who could control input costs could keep these charges as non-escalable components, while those that could not be controlled would be kept as escalable components. At the time of bidding, the values of escalation calculated based on the formulae prescribed by CERC could be used to evaluate the bids, while for actual payment, the escalable component would be determined on the same formulae and applied in the year for which the tariff would be determined.

Based on this, the bids could be evaluated on the evaluation parameter of “levelized tariff”, which is equivalent to time-weighted average of tariffs till the life of the project. All this sounded transparent, fair and prudent. But the success stories of imported coal-based projects awarded through these tariff-based competitive bids soon began to turn sour. Several of the successful bids were based on the assumption that coal sources in foreign countries would be under the control of the bidders as they could acquire coal mines and keep costs checked. NextMAds

The analysis of bidding patterns in these competitive processes indicates a wide spectrum of assumptions—some bidders assumed arms-length coal procurements from international market and kept the energy charges in the escalable basket. Some kept a larger proportion of these charges in a non-escalable basket in view of their existing or prospective acquisitions of mines, and several in between, depending upon their risk appetite and tolerance.

A key twist in the story was the Indonesian Law number 4 of 2009 that became effective in 2010 that put restrictions on the pricing of coal exported from the country. Most bidders in India drew up their coal procurement strategies with Indonesia as the source due to its vicinity and better economics of mining as much as coal quality parameters. The new mining law provided for global benchmarking for coal exports from Indonesia since the cost-plus transfers of coal was depriving the government there of royalty, which was ad valorem (linked to prices), and income taxes as these coal companies had barely any taxable income on account of cost-plus pricing. It may be noted that, during that period, coal prices in the international markets were at an all-time high and costs were much lower. Since the Indian power companies now had to buy coal from Indonesia, even from their own associate companies, at a global price, while their assumptions of procurement were at cost-plus, naturally these projects began to look unviable.

There are two crucial aspects to be considered here. One, that the bidding process had a provision for risk assessment by the bidders and some of them took what’s now considered an aggressive stance on fuel/energy charges based on their degree of control on coal mines in Indonesia. Hence, these could be a case of calculated risk that went wrong.

The other, and somewhat less considered, aspect is that for those bidders who own mines in Indonesia, the net impact on the whole may be much less severe. For those who own stakes in mines, the Indonesian rule will force such companies to transact at market prices, which may be seen as raising the cost of delivered coal in India. This is true but is not fatal. Taking a holistic view, the cash flows in an integrated Indonesian coal mining and Indian power generation unit after this regulation will continue to be similar, albeit a little lower, obviously, except that royalty and income taxes will be paid in Indonesia, and the cash flows will need to be brought on the books of the Indian power project after paying taxes in Indonesia through appropriate and innovative business structuring. In such cases, while the Indian power project company may likely lose, its Indonesian sibling would gain, keeping the ultimate parent company in a comfortable position.

Hence, it may appear that changes in Indonesian law could be fatal only to those bidders that had no ownership in mines in Indonesia and still chose to bid with aggressive non-escalable energy charges assuming lower coal prices. For such players, how much could we grieve?

It is agreed that fuel risks from foreign companies are not within the control of bidders at large. The future bids, through appropriate amendments to standard bidding document, must take that into cognizance. But for concluded bids, which also had provisions for prudence in risk taking, the CERC order could open Pandora’s box. The competitively bid projects awarded through a transparent processes may now line up for compensatory tariffs and raise questions about the sanctity of processes and contracts. sixthMAds

Dipesh Dipu is a partner at Jenissi Management Consultants, a Hyderabad-based resources-focused consultancy.