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Glass Half Full

While our power generation capacity has grown, distribution reforms have failed to keep pace…

The power sector has been an underperformer in recent times. Over the last one year (ended April 11, 2011), the BSE Power Index has declined 13.62 per cent whereas the BSE Sensex is up 7.9 per cent. Lack of reforms on the distribution side, inadequate provision of fuel for power generators, and declining merchant power rates are some of the factors responsible for this underperformance.

Upsurge in power generation: Since the enactment of the Electricity Act, 2003, power generation has taken off. During the eighth, ninth and 10th five-year plans, on an average 20,000 MW of capacity was added (in each plan period). During the 11th five-year plan the target was 78,000 MW, but we are likely to achieve 55,000 MW — almost two-and-a-half times the capacity added during earlier plan periods. Estimates of the capacity addition likely during the 12th five-year plan range from 70,000 MW to 1 lakh MW.
Strong private sector participation: Since 2003 private participation in power generation has increased. During the 11th five-year plan, almost 40 per cent capacity addition happened through the private sector. This figure is expected to rise to 50 per cent in the 12th five-year plan.
Equipment capacity being enhanced: Concomitantly, manufacturing capacity for the machinery and equipment required to set up power plants is also being augmented. BHEL’s capacity is expected to touch 20,000 MW per annum by the end of FY12. A number of private-sector players have entered the equipment manufacturing arena, such as L&T-Mitsubishi. These players are expected to add another 10,000 MW of capacity per annum for boilers, turbines and generators (BTG). Similarly, capacity on the balance of plant (BOP) side is also being enhanced.

Key concerns
Distribution reforms lag behind: While generation capacity has grown, reforms on the distribution side have lagged behind. Power distribution has so far been privatised only in Orissa and Delhi.
The financial condition of state electricity boards (SEBs) has deteriorated. According to the Economic Survey of 2010-11, losses of SEBs were of the order of Rs78,700 crore (about 1 per cent of GDP) in FY11. This is owing to a number of factors.
Aggregate technical and commercial (AT&C) losses in India remain high at 28.4 per cent compared to the targeted 15 per cent.
Inability to increase tariffs is another cause. According to a report from the Power Finance Corporation, regulators are today operational in 28 states, but only nine had issued distribution tariff orders by April 2010. This means that in the rest 19 states SEBs continue to bill at static rates despite the rising cost of power.
While cross-subsidy obligations (under-charging of agricultural sector and overcharging of industrial sector) of SEBs have increased, many state governments fail to compensate them: by FY09 (the latest year for which figures are available), SEBs were not compensated for 38 per cent of their total subsidy obligations. The state governments of Jharkhand and Rajasthan are the worst culprits in this regard.
The upsurge in generation capacity requires concomitant reforms on the distribution side. According to Puneet Goel, director, KPMG Advisory Service, “Over the last 20 years many public-sector utilities have become so run down that they lack both the financial and managerial capability required to significantly upgrade distribution infrastructure. So, on the one hand, more power is being generated, and on the other, consumers need more power. But the intermediate distribution mechanism has become a bottleneck.”
A state-wise analysis by Centrum Capital, however, reveals that of the 12 states that account for 85 per cent of power consumption, 10 are trying to curtail their losses. Chiefly four SEBs — those of Haryana, Madhya Pradesh, Rajasthan and Uttar Pradesh — need to reform aggressively.
Fuel shortages: While a huge amount of generation capacity is coming up, coal production is not increasing commensurately. CIL has given large commitments, but it has been unable to ramp up production to be able to fulfil these.
A number of captive coal blocks have been allocated to private-sector players, but production has not begun in those blocks due to a variety of reasons. One, the private sector players that have been allocated these blocks lack experience in mining. Two, the Ministry of Environment and Forests has notified certain areas as no-go areas. Many of the mining blocks allocated to companies fall in these no-go areas. The government has not yet decided on the fate of the blocks that lie within these areas.
Three, land acquisition is getting more complicated by the day and has emerged as a key challenge for the mining sector. Says Goel: “The government is yet to develop a framework that is transparent and equitable to all the parties: the government, corporates, and people. While industrial projects can be shifted to fallow, unproductive areas or those that are uninhabited, mining projects can’t.”
Finally, coal blocks have been allocated jointly to corporates. Many of them are rivals who don’t see eye to eye. Their bickering has led to delays.
Declining merchant power rates: In recent times, merchant power rates have been softening due to the weak financial condition of state electricity boards (SEBs) and declining power deficit. To reduce losses on account of their low tariff rates, SEBs prefer to go for load-shedding rather than purchase merchant power. Moreover, over the medium to long term, as more capacity gets added, merchant power rates are expected to decline. Analysts at Centrum Capital expect these rates to decline from an average of Rs6 per unit in FY10 to Rs3.3 per unit by FY13 — at par with long-term PPA (power purchase agreement) rates.

Choosing the best stocks
Players with assured fuel supply: Go for companies that have secured coal supplies either through captive blocks or through imported coal (many Indian companies have bought mines abroad). Such companies may be better placed than those that depend on supplies from Coal India. Tata Power, Adani, Lanco Infratech and JSW Energy are some of the players that have acquired coal mines abroad. However, remember that foreign mines are not a very cost-effective source: their valuations are rising as power and steel producers across the globe vie to buy them.
Players less dependent on merchant power: The country’s power deficit is expected to decline from the current 10 per cent to around 4.5 per cent by FY13, as capacity addition (about 13 per cent annually) outstrips growth in demand (around 6.5 per cent annually). Hence merchant power rates are expected to head southward.
Investors should therefore prefer players with long-term power purchase agreements over those that earn a greater proportion of their revenues through merchant power sales.
Avoid players with exposure to mismanaged SEBs: The poor financial health of SEBs has the potential to affect power producers. Most experts believe that payment defaults by SEBs are unlikely. But given their weak financial condition, many SEBs could reduce off-take of power, which would get reflected in lower merchant power rates. According to a recent report from Centrum Capital, Lanco Infratech and PTC India are two players that could possibly get affected by the poor health of SEBs. NTPC, CESC and Tata Power are likely to remain unaffected.

Attractive valuations
Valuations within the power sector are attractive currently: several majors such as CESC, GVK Power and Infra, NTPC and Tata Power are today trading at a price-to-book value that is lower than their five-year median P/BV.