Presentation to Honourable Central Electricity Regulatory Commission on Views/Suggestions on CERCs

1
Presentation toHonourable Central Electricity
Regulatory CommissiononViews/Suggestions
onCERCs Discussion Paper on Terms and Condition
of Tariff
November 12, 2003
2
Content

• Backdrop for Tariff Fixation
• Goals for Tariff Setting
• Part I Broader Issues of Tariff Setting
• Part II Views/Recommendations on Specific Issues
• Summary

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Backdrop for Tariff Setting
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Capacity Addition Required and past performance

• Huge capacity Addition Required to realize the
  vision of power for all by 2012 100,000 MW
• Estimated investment in all sectors Rs. 900,000
  Crs

• The Achievement in 9th Plan is lowest for all
  plans
• The need based targets for 8th and 9th Plan were
  44,000 MW and 57,735 MW respectively. The
  Planning Commission reduced the target
  considering feasibility/resources constraints
  etc.
• The Xth Plan target for utilities is fixed at
  41,110 MW.
• Considering the status of various projects
  identified for commissioning in this period, it
  is unlikely that this target would be achieved,
  even to a reasonable extent
• Accordingly, the shortages are likely to increase
  substantially

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Changing Structure
Structure Before Electricity Act- 03 (Post
Reforms)
DISTRI- BUTION
CONSUMER
GENERA- TION
TRANSCOs (eg. Delhi Transco) (Intra-State
Transmission, Bulk Power Purchase for Licensees)
Discom 1(Licensee 1)
LicenceArea 1
GENCOs
CPSU
Discom 2(Licensee 2)
LicenceArea 2
IPPs
Pvt. Licensees
Discom n(Licensee n)
LicenceArea n
Excess Captive
?
Regulators Role
No Choice to Generating Co./Consumer, Limited
Competition
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Changing Structure Emerging Structure Post EA
03
Generating Companies
Captive Generation Facilities
Own Generation
Transmission Network (Immediate Open Access)
Distribution Licensee 1
Distribution Licensee 2
Distribution Network (Gradual Open Access)
Own Distribution System
Licence Area
Power Traders would also be involved in some of
the transactions
Competitive, Flexible Structure enabling Choice
to Consumer
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Goals for Tariff Setting
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Goals of Tariff Setting

• Huge investment required (Rs. 900,000 Crs) to
  realize the vision of Power for All by 2012
• Investment in Power Sector to compete for
  investment in other sectors in terms of
• Returns offered
• Climate for investment Stable policies,
  regulatory and fiscal framework
• The policy of allowing an attractive return
  profile may be adopted for say the next 9-12
  years and when the critical mass of investments
  which can meet the 2012 vision is achieved, Govt.
  may review it
• This has happened in this country as well as
  abroad whenever Govts want to attract investments
  in certain sector.
• Thus tariff-setting principles need to
  distinguish between two stages - Stage I is the
  immediate period for the next 9 12 years when
  large investments would be required to meet the
  capacity requirements of the sector and Stage II
  would be the period thereafter.

Contd
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Goals of Tariff Setting (contd.)

• The need for attracting investments in Stage I
  is more acute compared to Stage II and at the
  same time more difficult
• State of the sector today, from investment point
  of view, is less favourable due to the various
  ills affecting the sector.
• Conditions likely to improve in the next 9 12
  years as reforms are accomplished and critical
  mass is achieved
• Case for more favourable returns in Stage I to
  attract investments.
• Normalized returns in Stage II
• Even in Stage I, a staggered approach to returns
  should be followed i.e., keeping in view the
  immediate need of funds, a higher return should
  be allowed for the next say 5 year period. The
  returns may then decrease in subsequent 5 year
  period and further decrease thereafter.

Contd
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Goals of Tariff Setting (contd.)

• Stable tariff policy framework in various stages
  and in inter-stages intervals, keeping in account
  large gestation period of power projects
• Clearances have a long lead time (for ex. MoEF
  clearance itself requires anywhere from 18 24
  months).
• Apart from ensuring the basic function of
  adequate cost recovery, it should ensure that
  there is enough revenue generation in the sector
  itself to partly meet the funds requirement.
• Ultimately, tariff setting should aim at helping
  the sector in its journey of reforms
  restructuring and should facilitate the emergence
  of a financially strong, vibrant, competitive and
  investor consumer friendly sector.

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Part ITariff Setting Broader Issue
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Tariff Setting Broader Issues

• Existing Practice Cost plus System
• Discourages efficiencies
• Financials
• Technological
• Operating
• Micro Management
• Detailed scrutiny of technology
• Technology/Equipment selection vetting
• Many time even capacities of sub-systems are
  analyzed
• Highly time consuming, taking lot of Commission's
  time and resources
• Not tuned to changing/dynamic structure
• Enhanced participation of private sector players
• Faster approvals (tariff etc.)

Pressing Need to move away from Cost plus System
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Tariff Setting Across the Chain Transition

1. Existing Structure Takes Time, lacks drivers to
   improve efficiencies
2. Desired Structure would take time to evolve

Need for interim Structure to cut down the time
and promote efficiencies
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Tariff Setting Interim Structure (Generation)
Interim
Existing
Regulated on Cost Plus basis
Regulated on Normative Basis

• Steps Involved
• (in each case)
• Cost Scrutiny/approval
• Financing Plan scrutiny/approval
• Scrutiny of interest rates

• Steps Involved (one time activity)
• Determination of Normative Cost
• Arriving at Normative Financing Plan
• Fixing Normative OM Cost
• Arriving at Normative Operating parameters

Faster approval process, uniform tariff for
similar projects Promotes efficiencies
Take time and Leads to separate tariff for
similar type of projects
Interim Structure to realize the Vision and
promote efficiency
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Part IIViews/Recommendations on Specific Issues
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1. Rate of Return Approach

• Views
• Tariff setting needs to move from a cost-plus
  approach to a normative performance based
  approach.
• Cost-Plus approach requires detailed analysis of
  the different loans, their repayment schedules
  and other terms conditions.
• It does not provide incentive to utility to lower
  cost of borrowings as even higher rates are
  passed through in tariff.
• Adoption of a Return on Capital Employed (ROCE)
  approach would incentivise utilities to adopt
  more efficient means of financing so as to reduce
  its cost.
• The ROCE may be calculated each year with
  normative cost of equity, debt and the
  debt-equity ratio.
• Recommendation

ROCE Approach to be Adopted
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2. Rate of Return ROCE- Cost of Debt

• Views
• The interest rate may be taken as lending rates
  for A rated borrower (minimum investment grade
  rating below which Banks/FIs generally do not
  lend).
• This may work out to a spread of 3 to 3.5 over
  the base PLR, which for simplicity, may be taken
  as SBIs Long Term PLR for Infrastructure
  Projects.
• A provision also need to be made for factoring in
  other costs of raising debt-finance viz. upfront
  fees, etc.
• Generally, lenders stipulate a call option in the
  loans which entitles them to review the rates of
  interest at regular period of time after
  disbursement of the loan (say every 5 years). No
  corresponding put option to the borrower.
• If interest rates in the economy go up, lenders
  may require enhancement of the interest rate
  applicable to the loan also.
• It would pose significant interest rate risk for
  the borrower which no borrower is in a position
  to take.
• Accordingly, there should be a provision for a
  mid-term review of tariff should the interest
  rates in the economy rise by say more than 3.
• Recommendation

SBI PLR 3.5 (on pre-tax basis), with provision
for Mid-Term Review to be Adopted
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3. Rate of Return ROCE- Cost of Equity

• Views
• Pressing need to attract investments in the
  sector and generate internal resources for huge
  capacity additions
• Returns, adjusted for Risk profile, to be
  attractive vis-à-vis competitive sectors for
  investments of the desired amount to flow in.
• The returns available to the investors should
  therefore be the opportunity cost of funds to the
  investor and not linked to interest rates in the
  economy.
• Against competing investment avenues, a cost of
  equity lesser than 16 would be definitely
  unattractive.
• In developed economies where there is no acute
  investment program, returns are linked to
  interest rates.
• Taking 16 as the base minimum ROE required, CAPM
  model may be used to see if a higher equity
  return is justifiable.
• The higher of ROE derived through the CAPM model
  and 16 should be used as the cost of equity.
• Recommendation

ROE of 16 (post-tax) to be continued at least
for Xth and XIth Plan Period
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4. ROCE- Debt Equity Ratio

• Views
• The generally followed a debt-equity norm of
  7030 in the past needs to be relooked in view of
  changing structure.
• From long-term assured off-take arrangements and
  elaborate payment security structures to
  liberalized competitive market place
• Less possibility of payment security structures
  and even if it is, experience of IPPs under
  operation shows how ineffective they are in
  actual practice.
• This would have the effect of slightly raising
  the risk profile of the investments.
  Additionally, the amount of investments required
  in the sector in the next 8-9 years also has to
  be seen.
• Considering the above, lenders may not be willing
  to lend at the same 7030 debt-equity ratio and
  may insist on a better debt-equity ratio.
• Moreover, credit profile of the borrower would
  also determine the debt-equity ratio being
  offered to him. For a majority of SEBs with poor
  financial health and a track-record of defaults
  on debt obligations, lenders may definitely like
  to insist on better equity cushion.
• Having determined these norms and approved tariff
  based on these norms, Commission should not look
  into what is the actual debt-equity ratio or the
  cost of borrowings for the company and the same
  should be left to the investors.
• Recommendation

For Calculation of ROCE, DebtEquity Ratio of
5050 to be adopted
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5. ROCE to be fixed or dynamic and fixed every
year?

• Views
• The investment decision is taken based on
  principles of ROCE allowed at the approval stage
• Changing principles of ROCE every year would lead
  to regulatory etc. uncertainties, which needs to
  be avoided
• If principles of ROCE norms is required to be
  changed, the revised norm should not be made
  applicable for fully developed/under construction
  or operation projects.
• In competitively bid project, the tariff offered
  by the bidder remains the same through the
  project life irrespective of change in tariff
  norms thereafter
• Recommendation

It principles should be fixed for project life
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6. Tax ROE to be Pre or Post Tax or increase ROE
by 0.5 to avoid pass through of Income Tax?

• Views
• In order to attract investment in the sector etc.
  16 ROE to be on Post Tax Basis.
• However, to avoid regular/yearly scrutiny, ROE
  can be specified on pre tax basis by suitably
  grossing it by effective tax rate over the
  project life
• Effective Tax rate to be computed by considering
  Section 80 IA benefit and MAT rate and initial
  depreciation shield.
• At current tax laws, the effective tax rate for a
  coal based power plant with a life of 25 years is
  21.13 and that for a gas based station is
  16.41.
• The ROCE would thus need to be enhanced by the
  above effective tax rates to make it on a
  pre-tax basis.
• To be adjusted for change in law/rate rates
• Recommendation

ROE to be Post Tax or to make it pre-tax,
suitably grossed up to effective tax rate
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7. Whether Additional Capitalization to be
allowed?

• Views
• Capital costs for stations various type of power
  plants should be based on laid down norms i.e, a
  fixed amount for various type of projects and
  considering the size of plant, economies of
  scale, etc. Thus for a gas based project, a
  normative cost of Rs. 3 crores/MW may be approved
  whereas for a coal based station, Rs. 4 crores
  per MW may be stipulated as the norm for capital
  cost.
• Once these norms are set, all cost components in
  tariff should be calculated w.r.t. these norms
  and there should be no linkage with the actual
  capital cost of the plant.
• All cost over-runs/savings w.r.t. this normative
  cost should be to the account of the developer
• Recommendation

Provision for mid-term review, if during
construction stage, there is significant
variation in tax laws impacting project cost
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8. Rate Base to be from assets side or liability
side?

• Views
• The calculation of rate base should ensure that
  the tariff allows a return component which covers
  both ROE as well as interest cost of debt.
• There are various options for calculating the
  rate base from the asset side liability side.
• The most prudent option would be one which allows
  flexibility to the developer, adequately covers
  his returns interest cost of debt and at the
  same time does not lead to a sharp increase in
  retail tariffs.
• As suggested earlier, Normative Approach should
  be adopted in this case also.
• The rate base, should take into account its
  reduction due to repayment of loan etc.
• Recommendation

1. Initial Rate Base Should be Normative Capital
   Cost
2. This may be decreased by 5 p.a., up to 50 of
   original, in view of debt-equity ratio of 5050

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9. Basis of Capital Cost Normative or Actual

• Views
• Taking actual cost as on COD would lead to
  different tariffs for similar projects
• Further, it would increase the steps required to
  fix the tariffs
• Recommendations

1. It should be on normative basis (due
   consideration to type of project, technology,
   economies of scale etc.)
2. There should be provision for mid-term review to
   account for any change in law/tax rates

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10. Treatment of Initial Spares in Project Cost

• Views
• In the existing tariff-setting methodology,
  initial spares are included as a part of the
  project cost.
• Further, there is a linkage between initial
  spares and calculation of maintenance spares for
  working capital purposes)
• Recommendations

1. Existing practice of including cost of initial
   spares in project cost to be continued. Normative
   project cost to be suitably adjusted for initial
   spares
2. There should not be any linkage between initial
   spares and calculation of maintenance spares

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11. Foreign Exchange Variation

• Views
• In a normative based tariff setting methodology,
  actual mode and mix of financing would not be of
  any issue
• Developer to optimize the financing package
• Recommendation

In view of suggestion for normative parameters
for tariff fixation and return on ROCE, this
issue does not arise
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12. Working Capital Issues

• Views
• Existing norms are based on prudent principles
  and well accepted
• Giving Interest on Working Capital along with
  ROCE would lead to its under recovery due to
  reduction in capital base over the period
• Interest rate needs to be uniform (charged to
  A rated borrower)
• Recommendations

1. Existing Norms to be retained
2. Interest on Work. Cap to be separate component of
   tariff
3. Interest Rate to be SBI PLR 3

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13. OM Expenses (Normative/Actual? escalation)

• Views
• OM cost should be on a normative basis as a
  given percentage of the normative project cost.
• Linking OM expenses to actual project
  cost/expenses leads to wide variation for similar
  type of projects.
• The actual OM expenses (including Insurance) are
  found be more than allowed in existing norms,
  particularly for gas based projects.
• As regards year-on-year escalation factor, a
  suitable weighted average of WPI and CPI may be
  used (say 60 WPI and 40 CPI).
• Recommendation

OM expenses (first year) allowed should be 4.25
for Gas Stations and 3 for Coal Stations of
Normative Project Cost
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14. Depreciation Rate

• Views
• Depreciation does not serve the purpose of loan
  repayment only. It also serves to generate
  additional resources which can be used for future
  creation of capacity.
• Realizing this, Govt. of India had also increased
  rates of depreciation in March, 1994.
• However, in a normative ROCE model, linking of
  depreciation rates to loan repayment exactly may
  not also be possible as there is no concept of
  actual equity or debt separation in the capital
  base.
• Recommendation

Retain Depreciation Rates as notified by MOP in
1994 (7.84 for coal 8.24 for gas stations, at
least for Xth and XIth Plan period
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15. Depreciation Other Issues

• Views
• The calculation of depreciation amount every year
  should be done on the basis of historic normative
  project cost (Not on economic/replacement cost).
•  Further, sector needs huge investment for
  capacity addition.
• Internal resource is key source of investment
  financing
• Recommendation

Depreciation to be calculated on normative cost
and should generate some surplus (over loan
repayment) for further investment
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16. Operational Norms for Thermal Stations

• Views
• The fixation of operational norms (station heat
  rate, secondary fuel consumption and auxiliary
  consumption) should take into account the
  relative performance of a wide cross-section of
  utilities in the country from both central
  state sector as well as the private sector so
  that the norms are achievable by all utilities
  which put in reasonably efficient efforts.
• The norms so fixed should also act as reasonable
  benchmarks for utilities to improve whose
  performance is below the norms.
• The existing practice of comparing norms against
  actuals and allowing the lower of the two
  discourages efficiency improvement measures.
• During stabilization period, norms should be
  relaxed.
• Recommendation

Norms to be based on performance of wide-section
of utilities and tariff to be based on normative
parameters only
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17. Norms for Target Availability

• Views
• The norms should take into account the relative
  performance of a wide cross-section of utilities.
• The average operating PLF/availability for all
  generating stations put together in the country
  stands at about 72, against stipulated norm of
  80.
• Wide-gap between the norms and the actual ground
  level performance
• The norms for target availability should thus be
  fixed at the national average plus say 2-3.
• Alternatively, if the threshold availability
  level is being raised to 80, then the ROE should
  also be enhanced from 16 suitably to reflect the
  higher risk carried by the project company.
• Recommendation

Target Availability should be 75 for recovery of
fixed charges including ROE _at_ 16
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18. Incentive (Linked to availability or PLF? )

• Views
• PLF depends on despatch of the plant, which is
  dictated by customer beneficiaries and not the
  developer
• Maintaining high availability is important for
  grid stability and should be rewarded
• Further, linking of incentives to PLF has a
  number of other shortcomings.
• Non-merit operation of grid
• Recommendation

Incentive should be linked to Availability
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19. Development Surcharge

• Views
• Development Surcharge was allowed in tariff to
  central sector utilities as a means of gathering
  surplus funds for future capacity additions.
• In a competitive market place, there is no reason
  why Govt. owned utilities should derive an
  advantage of securing cashflows for future
  investments by way of statutory levies/surcharge.
• If the Govt. so desires, the funds required for
  setting up new capacity should be given by way of
  planned budgetary allocations rather than collect
  the same by way of a surcharge.
• The surplus funds for future capacity addition
  can be generated through a higher rate of
  depreciation etc. which would then be uniformly
  available to all utilities and not to central
  sector utilities only.
• Recommendation

Development Surcharge should not be specific to
fund investment program of Central Generating
Stations
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Transition Period Support Need for
Cess/Surcharge

• Distribution Sector Transition Phase Need for
  Support
• Low retail tariff elasticity
• Need to keep retail tariffs affordable for all
  consumer categories
• This may be ensured by
• Reducing losses
• Tariff rationalization
• Operational/organizational efficiency improvement
• However, these measures would take time
• During this period sustainability of the utility
  to be ensured
• Therefore support required to bridge the gap
  Actual tariff minus regulated tariff
• Most State Govts do not have resources to bridge
  this gap major constraint to distribution
  privatization reforms
• CERC requested to recommend to Central Govt. to
  levy a cess on all power sold in the country to
  meet transitional period support
• Surcharge Collection to be administered by the
  Excise Machinery.

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Transition Phase Need for Support (contd.)
Revenue Gap Govt. Support
?
Without reforms perpetual drain on Govt.
resources
With reforms
Transition Period
Reforms to release Govt. funds for priority
sectors
37
20. Tariff Norms Review Period

• Views
• Tariff policy framework should be stable enough
  for a reasonable period of time
• keeping in view the development period of
  projects
• However, periodic review is necessary
• Changes in cost levels in economy, technology,
  equipment prices
• Revised norms to be applicable for new projects
  only
• For fully developed/set-up projects, tariff
  principles once set, should continue for the
  entire life of the plant.
• The investment decision and financing is based on
  prevalent norms
• The apprehension of customers that escalation
  component (viz. OM cost) may become very high
  compared to actuals can be taken care of better
  by suitably determining the escalation factor
  with weights linked to various indices of costs
  in the economy.
• Recommendation

Tariff norms may be reviewed once in 5 years, to
be applicable for new projects only. No change
for fully developed/operating projects
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21. Regional Tariff (i.e. Pooled Tariff for CPSU)

• Views
• The need for pooled generation tariffs is not
  clear.
• Generation tariffs should be on station-wise
  basis and not pooled basis.
• Pooled tariff concept is generally applicable for
  distribution utilities when they procure bulk
  power and not for generation companies.
• The pooled tariff concept for generating
  companies can work specifically in a
  short-term/spot sales scenario.
• In case of long-term contracts, it would become
  very difficult to implement a provision whereby
  tariff gets upwardly revised every time a new
  incremental capacity is set up.
• Recommendation

Tariffs should be stationwise
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22. Peak/Off Peak Tariff in Bulk Generation

• Views (whether should be introduced?)
• The concept is in the right direction.
• Compels distribution companies to manage load
  curves in a more efficient manner
• Ensures higher availability of generating
  capacity during peak hours
• reduce congestion on transmission lines to some
  extent
• However for it to be really effective,
  differential tariffs based on time of day etc.
  should also be implemented at the downstream
  level i.e., transmission distribution business.
  
• If this is not the case, the distribution
  licensee/supplier would end up getting squeezed
  by the higher peak bulk tariff rates which he
  would not be able to pass to the retail
  consumers.
• There should be a clear road-map for appropriate
  TOD metering/retail tariff fixing, etc.
• Recommendation

Differential Tariffs should be introduced
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23. Declared Capacity Auxiliary Consumption

• Views/Basis for Recommendation
• Existing definitions are well accepted and
  understood in the Sector
• Recommendation

No need to change the definitions
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Goals for Tariff Setting Other Issues
42
Need for Intra State ABT

• Currently applicable only to Central sector
  generators and beneficiaries who are directly
  connected to and are a player on the regional
  grids (Inter State only).
• The advantages not being completely utilized by
  the entire power sector
• On the intra-state level, a significant surplus
  capacity exists with various generating companies
  CPPs which at present is not being optimally
  utilized.
• Moreover, a number of state generating stations
  still have single part tariff, which is not in
  line with merit order regime. Such generating
  stations would be asked to back down even though
  on a variable-cost based merit order system they
  would have been fully dispatched.
• It is also necessary that the distribution
  utilities become more accountable in their load
  management processes by assessing consumer demand
  more accurately and planning their load shedding
  schedules judiciously.

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Need for Intra State ABT

• Unbundling of SEBs would increase no. of players
  managing the load in the system.
• Unless a mechanism is put into place at the
  intra-state level to cover these distribution
  companies also under ABT, the loop would not be
  closed and the actual implementation of ABT would
  not be complete.
• Thus, implementation of ABT at the intra-state
  level would free up idle generating capacity
  leading to meeting of more consumer demand,
  ensure better load management by the distribution
  companies, boost bilateral trading, etc.
• ABT with a self contained discipline mechanism
  would enable better and reliable grid operations

44
Advantages of Intra State ABT

• The experience of implementing ABT in the country
  till date has shows following major advantages
• The UI charge in ABT results in better grid
  discipline and grid security by limiting grid
  frequency excursions within a manageable range.
• Improvement in grid voltage levels leading to
  reduction in transmission losses and enhancement
  of transmission capacity.
• Maximization of generation during peak-hours and
  backing down of generation during off-peak hours
  as per merit order. ABT facilitates Merit Order
  Dispatch as the fixed cost payable based on
  capacity allocated becomes a sunk cost and
  dispatch of plants is based on variable costs.
• The two-part tariff concept of ABT presents an
  inherent platform for bilateral trading.
• Improvement in performance of power plants by
  reducing trippings and long term damage.
• Improvement in commercial dealings with reduction
  in year-end adhoc adjustments and consequent
  disputes.

45
Summary
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Summary Tariff Setting Goals

• Tariff setting to take into account changing
  structure of power sector
• It should lead to faster approval process
• Normative cost etc. approach
• It should promote efficiencies

47
Thank you