New Delhi: The National Democratic Alliance (NDA) government has offered a bailout plan for state government-owned electricity distribution companies (discoms) in a move that could fundamentally change India’s power sector and also reduce the stress on books of banks that have loaned money to these financially unsound utilities.

The plan approved by the Union cabinet on Thursday has a better chance of succeeding than two previous ones as it also aims to enforce financial discipline on the states. The plan also comes in the backdrop of at least 10 states going to polls over the next two years.

As part of the Ujwal Discom Assurance Yojna, or UDAY, adoption of which is optional, the states will have to take over 75% of the debt of discoms. These loans will not be included in calculation of the state’s fiscal deficit till 2016-17.

In addition, the states will issue bonds and the balance discom debt will be converted into loans or bonds at concessional rates.

A tripartite agreement between the Union power ministry, state governments and the discoms will be signed as part of the bailout plan.

The plan comes at a time when state electricity boards (SEBs), with a combined debt of 4.30 trillion and losses of around 3.8 trillion, are on the brink of financial collapse. This has made them averse to buying electricity, which affects the viability of power plants (and the banks that have loaned money to them). The majority of the overall debt is held by utilities in the eight states of Rajasthan, Uttar Pradesh, Haryana, Tamil Nadu, Andhra Pradesh, Jharkhand, Bihar and Telangana.

“Financially stressed discoms are not able to supply adequate power at affordable rates, which hampers quality of life and overall economic growth and development," the government said in a statement. “In addition, default on bank loans by financially stressed discoms has the potential to seriously impact the banking sector and the economy at large."

Many distribution utilities are saddled with losses arising from theft, besides transmission and billing inefficiencies. They often purchase expensive power to tide over short-term deficits and many utilities are yet to revise tariffs to the desired levels. The poor financial health of these utilities means they cannot raise debt. West Bengal, Assam, Kerala, Tamil Nadu and Puducherry will hold assembly elections in 2016. Uttar Pradesh, Punjab, Goa, Manipur and Uttarakhand will go to polls the following year.

“Financial liabilities of discoms are the contingent liabilities of the respective states and need to be recognized as such. Debt of discoms is de facto borrowing of states which is not counted in de jure borrowing. However, credit rating agencies and multilateral agencies are conscious of this de facto debt in their appraisals. In line with the above and similar observations of Fourteenth Finance Commission, States shall take over 75% of discom debt as on 30 September 2015 over two years—50% of discom debt shall be taken over in 2015-16 and 25% in 2016-17. This will reduce the interest cost on the debt taken over by the States to around 8-9%, from as high as 14-15%; thus improving overall efficiency," the government statement added.

To be sure, this is not the first bailout plan for the power distribution firms.

This is the third such bailout for the Indian distribution sector in around 13 years; the first two failed to incentivize the states to act.

Power minister Piyush Goyal expressed confidence that the bailout will be a success this time because of the hard budget constraints being put on the states to ensure that their SEBs do not slip back into losses.

“Starting from 2017-18, the loss that a discom may incur will in a graded fashion be taken over by the state and will be considered for the state’s fiscal deficit FRBM (Fiscal Responsibility and Budget Management) targets. In 2017-18, 5% of the previous year’s loss; in 2018-19, 10% of the previous year’s loss; in 2019-20, 25% of the previous year’s loss and by 2020-21, 50% of the previous year’s loss will have to be taken into the FRBM fiscal deficit targets of the states," he said, adding that by 2018-19, states should have zero losses.

“We are also advising the banks not to lend any further money for financing the discom losses. Banks should run their loan book based on prudential norms to ensure that most of the states’ SEBs come into profits," Goyal said.

He pointed out that this will be a significant departure from the previous bailout package wherein banks were funding the operating losses of SEBs.

Experts welcomed the move.

“I rate it as more comprehensive than any other SEB restructuring scheme seen till date. It talks about cost-side efficiency such as immediate reduction of interest service burden, reduction in fuel cost through coal swapping, time-bound loss reduction, etc. On the revenue side, it talks about a strict discipline of quarterly fuel cost adjustment, annual tariff increase, taking regulators on board and finally including discom losses in the FRBM limits for the states," said Debasish Mishra, senior director, consulting, Deloitte Touche Tohmatsu India Pvt. Ltd.

“It’s indeed a discom revival plan and not limited to debt restructuring. It has all the three elements—clear up the legacy issues of past losses and debt, provide a financial road map to bring tariffs in line with costs by FY19 and provide enough deterrents for the state government to not allow the state discoms to become loss ridden post FY18—as losses start to impact their FRBM limits," said Sambitosh Mohapatra, partner, power and utilities, at PricewaterhouseCoopers Pvt. Ltd.

Banks were equally enthused by the development.

“The portion of the discom debt which is under restructuring will be converted to bonds so that is obviously a positive. The provisions made for that restructuring will be written back once they are converted. The interest income on the loans may be affected slightly due to conversion at a lower rate than the interest on the loans, but the trade-off is still better than letting these assets die. Bankers will obviously be cautious in lending more to these discoms in the future," said Ashwani Kumar, chairman and managing director, Dena Bank, and chairman, Indian Banks’ Association. “But now that the pressure to survive and perform is on the state government, it gives banks a lot more comfort."

According to another senior banker, who asked not to be identified, the fact that 75% of the discom debt will be taken over by the states will solve a large part of the problem facing the banks.

Pretika Khanna in New Delhi and Vishwanath Nair in Mumbai contributed to this story.

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