Project Report

Challenges and Opportunities in Joint Ventures & Turnkey Contract jobs in Indian Power Sector

CHAPTER 4 FINANCIAL ASPECTS 4.1 INTRODUCTION

The Indian Power Sector has been weighed down by the political and regulatory environment along with the in efficiencies of the State Electricity Boards (SEBs) and chronic shortages and pressures to meet demand. This has deterred private investment from flowing into the sector. The government's first stab on this i.e. the1990s strategy of bringing in global sponsors to build Independent Power Producers (IPPs) was not particularly successful and Dhabol plant left a bad taste in everyones mouth. But with the passage of Electricity Act 2003, new rays of hope have opened for growth. The Electricity Act has an overall positive impact on the profitability of the power sector and encourages investment and efficiency. The new power strategy visible in India has much more of a domestic flavour even though bidding is open to foreign players. The government is keen to attract significant private capital into its power sector, which is facing a huge demand-supply gap. Badly affected states such as Maharashtra have 19% energy shortages, and this can rise to 27% peak power shortage levels. This power shortage is holding back industrial growth and corresponding economic development, and the World Bank has estimated that if India is to sustain current GDP growth levels in the 8% to 9% per annum range, it will need to add 160,000 MW of generating capacity over the next 10 years. The basic template evident is domestic sponsors raising cash on the stock market, and using this source of funding as the project equity component for competitive bids. In this new environment, Project Finance will be the key financing mechanism for growth. Also the investment will have to be directed towards all the components of the electricity delivery chain i.e. Generation, Transmission and Distribution. This would help India to overcome the bottlenecks in the long neglected Transmission and Distribution segments. The financing also needs to move to the next level of Public Private Participation with the Financial Institutions providing equity to the sector and not just debt. The sector also needs incentives in the form of lower duties, tax holidays and measures such as a higher return on equity (RoE) to attract more investments. Payment risks associated with SEBs which has been a major concern for IPPs have overcome to some extent with SEB restructuring and improvement in the security and payment mechanisms arrangements. But a word of caution needs to be attached to this optimistic view as the efficacy depends on the commitment of the Centre and State machinery to the reforms process. Except for the limited success by a few generation companies in accessing the debt market, transmission and distribution utilities have not managed to raise debt successfully from the open market. The availability of easily accessible debt from government backed financial institutions like the Power Finance Corporation (PFC) and the Rural Electrification Corporation (REC) has had the effect of "crowding out" the development of a private debt market. It is therefore important that these institutions scale down their activity, and confine themselves to the smaller and weaker utilities. The state utilities are too cash strapped for internal resources to be of any significance. Given the excellent commercial potential of merchant power plants, the equity market is a good source of raising funds. In any case, the Indian equity and especially debt market is too narrow Chapter 4 - Financial Aspects Page 1 of 6

Project Report

Challenges and Opportunities in Joint Ventures & Turnkey Contract jobs in Indian Power Sector

and does not have the required depth and breadth to finance these huge requirements. It is therefore inevitable that Foreign Direct Investment (FDI) be incentivized, so as to meet the huge investment requirements. 4.2 PROJECT FINANCING The Indian economy is poised for higher economic growth in the years to come. This will require large investment in the infrastructure sectors including the power sector. The National Electricity Plan of India aims to provide access to electricity to all households by 2010 and to meet all shortages by 2012. This will require an investment of around USD200 billion to finance generation, transmission, distribution and rural electrification projects. During the 1990s, up to 80% of power sector funding came from the public sector, followed by the private sector (1015%) and official development assistance (510%).Increasingly, both the central and state governments are facing the need to meet competing budgeting requirement from other social sectors such as health and primary education. The need for enhanced fiscal discipline and macroeconomic stability is also placing a limit on borrowing capacity of the government both at central and state level. Given the limited fiscal space for budgetary support for such investments, greater private sector participation is inevitable. Inefficiency, administrative bottlenecks and poor and inadequate infrastructure facilities, in particular continued shortage of electricity in India under public ownership has necessitated enhanced private participation in the sector. Power sector reforms have been initiated in India with the aim of creating an enabling environment for private investment thereby helping to bridge the gap in public investment. Persistent power shortages, inadequate public investment and the economic crisis faced by India in the early 1990s led to the opening up of the power sector to private investment and major policy initiatives were undertaken to encourage private and foreign investment. The investment climate was further strengthened through gradual restructuring of the state electricity boards (SEBs) and initiation of regulatory reforms at the central and state level. More recently, enactment of the Electricity Act 2003 includes enabling provisions for enhancing competition in the sector and to improve the environment for private participation. The abolition of the single buyer model and phased access to consumers has unlocked substantial potential for private investment in the sector. TYPES AND SOURCES OF FINANCE

DEBT Given the capital-intensive nature of power projects, mobilization of long-term debt becomes critical to the development of power projects. Project finance debt is generally secured by projects assets such that after paying operating expenses, debt and debt service is paid from cash flows. Debt typically constitutes up to 70% of the power project costs in India. The type of debt used in power projects finance structures has been varied. The following are some of the sources of debt available to power projects developers: GOVERNMENT Traditionally, the main source of debt has been the government. Both the central and state governments lend the money to utilities from time to time for Chapter 4 - Financial Aspects Page 2 of 6

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Challenges and Opportunities in Joint Ventures & Turnkey Contract jobs in Indian Power Sector

expansion plans or working capital. They extend loans for longer tenure and at lower interest rates than commercial rates. MULTILATERAL AGENCIES In the past, multilateral agencies have funded expansion plans of central utilities such as NTPC, NHPC or PGCIL. In the mid-nineties, they switched their focus from lending to support power sector reforms in states aimed at mobilizing investments and increasing economic efficiency. They have funded restructuring and reforms efforts of SEBs. The tenure of these loans typically ranges from 15-25 years, with moratorium of five years. However, the investments yielded limited results, with the state governments faltering on the milestones attached to the funding. Subsequently, the agencies discontinued lending to state reform programmes. In the last couple of years, these agencies have shown greater confidence in the sector, mainly due to Electricity Act 2003 and follow-up policies. Majority of the funds from these agencies are still provided to Central Public Sector Undertakings (CPSUs). COMMERCIAL BANKS AND FINANCIAL INSTITUTIONS Commercial banks and Financial Institutions (FIs) have consistently increased lending to power sector in the last 4-5 years. Most of the lending has been skewed towards the generation segment. With the opening up of the T&D segment to the private sector, commercial lending is likely to increase in future. For generation projects, the standard tenure of loans is 13-14 years, which included construction period and repayment period of 10 years. Earlier the lending use to be under recourse financing, but in the last 4-5 years, the lending institutions have become more liberal and comfortable with lending to bankable power projects. Although, commercial banks and FIs continue to increase their exposure to the power sector, individual exposure of banks to the sector remains limited. This is mainly because they are still constrained by financing limits as per prevalent prudential norms prescribed by the Reserve Bank of India (RBI). NICHE INSTITUTIONS There are also niche institutions such as Power Finance Corporation (PFC) and Rural Electrification Corporation (REC), which provide loans specifically to power sector. While PFC provides loans for all kinds of investments, REC focuses mainly on rural electrification. The state sectors reliance on these institutions for debt is very high mainly due to the competitive rates and liberal terms and conditions offered by them. In the recent past, due to their experience and expertise in the sector, these institutions have been competing with commercial banks. Moreover, since issues like asset-liability mismatch and exposure limits are not applicable to PFC and REC, it is easier for these institutions to lend to the sector. INSURANCE COMPANIES Insurance companies like the Life Insurance Corporation of India (LIC), General Insurance Corporation of India (GIC) have extended financial support to the power sector. There are limits on the investments prescribed by the Insurance Regulatory and Development Authority of India (IRDA). Life

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Challenges and Opportunities in Joint Ventures & Turnkey Contract jobs in Indian Power Sector

insurance and general insurance companies have to invest at least 15% and 10% of the fund respectively to the infrastructure and social sectors. EXTERNAL COMMERCIAL BORROWINGS External commercial borrowings (ECBs) were quite a popular means to raise finances until some time back, especially for large projects funding. These loans are raised at Libor-plus rates, which are generally lower than the interest rates in the domestic market. ECBs have declined of late due to RBI restrictions on foreign funds flows for rupee expenditure and due to an increase in borrowing costs as a result of the sub-prime effect. EXPORT CREDIT AGENCIES Loans from export credit agencies are cheaper than commercial loans and are generally used when equipment needs to be imported from a particular country. These are likely to gain importance in the medium term mainly fuelled by the requirement of importing super-critical units in the eleventh and Twelfth plan periods, and until this demand is met by the domestic market. BONDS Several utilities and state power corporations have resorted to issuing bonds to raise funds. These are generally subscribed by provident and pension funds, gratuity trusts, insurance companies, mutual funds, individual, etc. These bonds typically have tenure of 7-8 years. EQUITY The equity in power projects, like in other projects, is driven by the rate of return that is expected from the investment apart from acting as a cushion to project finance. In the power sector, the return on equity is fixed at 15.5% on 30% of the equity investment. The sources of equity are promoters equity, internal accruals, equity funds and strategic equity investors. Raising funds from capital markets is also becoming increasingly popular. The following are some of the sources of equity available to power project developers: PROMOTERS EQUITY AND INTERNAL ACCRUALS Most project developers invest some amount of the total project cost as promoters equity to be able to earn the minimum return on equity and raise the required debt. Many CPSUs, including National Thermal Power Corporation(NTPC) are increasingly relying on internal accruals for investing equity in new projects. PRIMARY/CAPITAL MARKETS In recent times, power sector companies have been raising funds from primary markets through Initial Public Offerings (IPOs). Almost all IPOs of power companies in the last two to three years have met with an overwhelming response from investors or have been performing well in the stock markets. Some of the successful IPOs have been those of CPSUs like NTPC, and PGCIL, private developers like Suzlon Energy, JP Hydro and Reliance Power and infrastructure companies like GMR, GVK and Lanco. Many power companies are expected to launch their IPOs in the coming years. NTPC is also planning to come out with a follow-on public offer. Chapter 4 - Financial Aspects Page 4 of 6

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Challenges and Opportunities in Joint Ventures & Turnkey Contract jobs in Indian Power Sector

4.3 QUALIFIED INSTITUTIONAL PLACEMENTS Another source of equity, which is increasingly being tapped by power sector companies, is private placement with qualified institutional investors. For instance, GVK Power & Infrastructure Limited (GVKIL) and Kalpataru Power Transmission raised USD 300 million and USD 85 million respectively through this route in May 2007 and September 2006 respectively. PTC India also raised around USD 29 million through this route in January 2008 by allotting shares to institutional buyers like LIC and Morgan Stanley, among others. 4.4 EQUITY FUNDS Specialized equity funds such as India Development Fund by Infrastructure Development Finance Company (IDFC) have been set up to invest in equity in private sector power sectors. The India Power Fund by PFC which was expected to be launched in 2004 is however, yet to start operations. India Infrastructure Finance Company Limited (IIFCL), Citigroup, Blackstone have also instituted a USD 5 billion India infrastructure financing initiative for investing in infrastructure projects. The Anil Dhirubani Ambani Group and Singapores Temasek Holdings constituted the Reliance India Power Fund with equal contributions. Others planning to set up infrastructure funds, which would pick up equity in power projects as well, include a USD 2 billion infrastructure by ICICI bank, the USD 1 billion Macquarie India Infrastructure Opportunities Fund by Macquarie and International Finance Corporation (IFC), a USD 1 billion India focused infrastructure private equity fund by Standard Chartered and IL&FS Investment Managers and a USD 2 billion India Infrastructure Fund by JP Morgan and Chase Company. PTC Indias investment arm PTC Financial Services also plans to pick up equity in power projects through an Energy Equity Fund. 4.5 TRENDS IN POWER SECTOR FINANCING Increased investor confidence resulting in commitment and disbursement of more funds IPP revival triggered by increased investor confidence Gradually increasing interest rates leading to increased project costs ,Increased availability of longer-term debt Skew towards investment in generation continues External Commercial Borrowings (ECB) loses sheen as RBI tightens norms . As local capital market mature, more companies are opting for IPOs Lenders no longer demand government guarantees, counter guarantees. Bankable and competitively priced projects are able to raise funds easily. Project financing criteria relaxed by financiers for new types of projects. Promoters track record is a important consideration 4.6 KEY POWER FINANCING Power companies continue to raise funds through a variety of vehicles including public offers, bond issues and debt syndication. Multilateral agencies have shifted back to utility finance. Commercial Banks and FIs have also increased lending to the sector apart from PFC and REC. The IPP segment has seen renewed vigour.

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Challenges and Opportunities in Joint Ventures & Turnkey Contract jobs in Indian Power Sector

4.7 CENTRAL SECTOR PROJECT FINANCING In the past, NTPC and PGCIL have raised funds in the form of equity and debt. Their equity component includes internal accruals, government budgetary support and joint ventures (JVs), while the debt component comprises private placement of bonds, market borrowings from FIs and niche institutions and loans from multilateral agencies. The following are the details of some of the recent financings: 4.8 NTPC In September 2006, NTPC entered into a loan agreement of USD 300 million with Asian Development Bank (ADB) under latters complementary finance scheme for Sipat and Kahalagaon Stage II projects. In February 2007, NTPC received a grant of USD 12 million from the ministry to implement 14 distributed projects. The grants were given under the Ministry of Powers Delivery through Decentralized Management (DDM) scheme. In March 2007, NTPC signed a loan agreement of USD 100 million with KfW to part finance the expenditure on R&M of NTPC plants. This is the first loan provided by KfW directly to NTPC. In July2007, NTPC signed a MoU with ADB to set up a JV for renewable power generation. NTPC and other government entities will hold 50% stake, while strategic investors will hold the remainder. ADB is expected to acquire 20% stake at a later stage. The JV is expected to hold a portfolio of about 500 MW of renewable generation over the next three years, the initial focus being wind power and mini and micro hydro power projects. PGCIL In 2006-07, PGCIL undertook capital investment of USD 1.5 billion. Of this it mobilized USD 1 billion through private placement of bonds and the balance from internal resources and multilateral agencies. In the past, World Bank has extended USD 450 million as loan to PGCIL for Power grid System Development Project II in 2001 and USD 400 million for Project III in 2006. Other multilateral agencies such as ADB and JBIC have extended a USD 400 million in 2004 and USD 3.14 billion in 2005 respectively to PGCIL. For funding its future projects, PGCIL is negotiating with the World Bank and ADB for loan assistance of USD 600 million each. Major Financiers in Power Sector Power Finance Corporation , Rural Electrification Corporation ,World Bank , International Finance Corporation , Asian Development Bank , Japan Bank for International Cooperation , Kreditanstalt fuer Wiederaufbau , Department of International Development , India Infrastructure Finance Company Limited , Infrastructure Development Finance Company , Life Insurance Company , Punjab National Bank , ICICI Bank , IDBI Bank , State Bank of India , SBI Capital Markets

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