VERTICAL INTEGRATION

An analysis on Essar Power Gujarat Limited

Alternative growth strategies-

Internal Ex pansion
Vertical Integration A business growth strategy that involves expanding within an existing market, but at different stages of production. Why business might wish to expand via vertical integration?

Greater Efficiency- When vertical integration results in a fall in businesss long-run average costs, it is effectively experiencing various economies of scale. 4 categories under which it might lead to cost saving Production economies Co-ordination economies Managerial Economies Financial Economies Reduced Uncertainty Monopoly Power Barriers to Entry

D ifferentiation - increase in m arket share

V rtic l In g a e a te r tion - d r iffe p u tb t te h ic llyre rod c u c n a la

(Figure- Showing the demand and supply of electricity in INDIA)

My analysis is based on ESSAR POWER GUJARAT Ltd. (EPGL), a company where I worked for 2 years. EPGL is a coal based thermal power plant project with generation capacity of 1200 megawatt one of the many business sectors of ESSAR group operating globally. The other businesses are mining, oil & gas, steel, BPO and IT, Projects, ports, shipping.

1 http://www.oecd.org/dataoecd/39/15/40633690.pdf
India: Growing Energy Needs and Mitigation Options Gireesh B. Pradhan, IAS Additional Secretary, Ministry of Power, Government of India. 5th May 2008

2 Power business unit

Essar Projects executes power plants across a diverse portfolio of gas-based, coal-fired and renewable energy sources. It was also the first private company to obtain a power transmission license in India. Some of its major completed projects include 515 MW combined cycle multi-fuel power plant, Hazira, Gujarat; 120 MW captive co-generation multi-fuel power plant at Vadinar, Gujarat; 500 MW gas-fired combined cycle power plant at Bhander, Gujarat; etc.

Vertical Chain for EPGL

(About factors required to commission and generates electricity from power plant)

Factors of Production Land

In-house/ Outsourc ed In- house

Provider

Owned by Essar

Coal (Raw Material)

In-house

Provided by Essar Mining Ltd.

Equipments and Machinery

Outsourc ed

Imported from Harbin Power Ltd. (CHINA)

Transportation of Material from China to India

Outsourc ed

Shipping Contract to Global Suppliers

Project Cargo In-House Unloading at Port

Equipments and Materials are unloaded at Essar Port.( owned by ESSARprivate port)

Transportation of material to the project site

Outsourc ed

Transportation by road- under the contract with Kataria Transport

Project Design

Outsourc ed

Provided by Tata Consultancy services

Work force In-house (experienced and skilled labour to build up )

Experienced people from Essar Projects Ltd (EPL)

Information and Telecommunication Setup

In-house

Setup done by Essar IT ltd. (EITL)

Security at project Outsourc Site ed

Under the contract with SIS Securities

Electricity produced is transmitted to the Transmission Substation (power grid), from where its distributed to the user. This process is carried out by state government

Analysis LandAsset Specificity- Ever increasing demand of land, scope to use it for different purpose, increase in value with time provides company the advantage. Uncertainty- It is eliminated as it is not bound by any contract or legal obligation. In-house factor helps them to be safe. Transaction Cost- is high in terms of negotiation and proper preparation of legal documents but it is one time cost. So company can bear it looking at the future valuation of land.

Coal-

Numbers of firms- Few firms have coal mines as their property. This increases their capital value as company holds natural resources.3

3 Low Cost Power Producer

by using the latest technology and equipment, Essar Power can generate and supply power at very competitive price points. In addition, our operational costs are reduced because of our plants access to dedicated raw material sources. Essar owns coal mines in Indonesia and Mozambique, which gives Essar Power access to an estimated resource base of 100 million tonnes of high quality coal. Our power plants employ a high level of automation, which translates to Indias lowest manpower-to-megawatt ratio.

Scope for opportunism - Can sell surplus to other firms at higher price. In case of coal, supplier has got high bargaining power than buyer. (Normal
price of coal in market is $130/tonne while it cost only $78/tonne for EPGL)4

Eliminates Uncertainty- Sudden price increase due to shortage in quantity or due to change in government regulation can put financial pressure on the firm. It also decreases the dependency on other party for raw material. Transaction cost- Owning coal mine will incur one time transaction cost in terms of complete authority and legal fulfilment. But for Essar Mining, Essar Power will be priority so company can afford one time transaction cost and EPGL will get timely supply.

Equipments
Number of firms - Many firms are present globally giving EPGL many options and get bargaining opportunity while finalizing the contract. Complexity of Production-manufacturing equipments is not critical. With modern technology it is easy to manufacture power plant equipments in less time. Transaction cost- It can be borne by the company because if this would have been in-house then Essar would require huge investment to set up the infrastructure so that it could manufacture the equipments. Moreover it has to find more business after the demand from EPGL is fulfilled.

Shipping of material High chances of uncertainty- due to sudden demand for statutory documents or sudden payment terms before the unloading causing delay in project work. Scope for opportunism The shipping company can impose sudden changes in freight rates by stating change in fuel price or objecting to the nature of project material loaded in the ship (over sized material). Increases the transaction cost in terms of Identifying the best service provider ( at international level) Negotiating the contract Monitoring of compliance Enforcing the fulfilment , to deliver the project material as early as possible ( but EPGL is one of the customer not only)

Having executed all of its power plants, Essar Power has built expertise ranging from project conception to commissioning, including engineering, procurement and construction. Our plant operation and maintenance standards are comparable to the worlds best. This is demonstrated through a high plant availability of over 96 percent and a plant load factor of over 85 percentSource- (www.essar.com)

4 Information taken from personal interaction with the EPGL main office.

 PortMonitoring cost is reduced as it is within the self operated port. Unloading, material handling and loading on trucks all this processes can be carried faster with less supervision and direction. Economies of Scale asset will be utilized optimally. Infrastructure, jetty, natural draft provided by sea can be used and it will not incur extra cost once built and used number of times. Reduce the uncertainty- like clearance from custom department. As the port belongs to particular company, government provides dedicated officer to look after clearance and checking of the material arriving through sea route.

Truck transportationNumber of firms- There are number of firms providing the transportation business. This creates the scope for bargaining and getting the service at competitive price. Can create diseconomies of scale- Material is transported by trucks and it starts on 24 hrs basis when material arrives at the port. To transport the material on site within less possible time and material handling process at the port, it requires nearly 35-40 fleets of trucks and 3-4 cranes (hydraulic type and high capacity) which are huge investment. During the ideal time when ship is not scheduled and material are not available to transport the vehicles remain ideal. If it is in-house the maintenance also has to be looked after by EPGL. Less monitoring cost- One person at office can coordinate and direct the transport contractor regarding the ship schedule and arrival of material at port.

Low transaction cost- E-tendering is used and applications are invited. This makes the process of finding the potential service provider very easy.

Design-

Firm Specific Knowledge- The designing of the project is very crucial and is of vital importance. A good design can save the project cost and increase the efficiency of the operation by saving fuel requirement, using automated technology, proper piping layout design. Uncertainty- Whenever there is confusion or doubt in the design EPGL has to rely on the service provider for the solution. As piping or structure has to be fabricated on the site, once it is made it would cost more if it has to alter as it consumes time, labour and cost of raw material. Number of firms- There are less number of firms who provides the design of the whole project as it is very specific and varies a lot from one project to another.

Increase the scope of opportunism the service provider can charge more by stating it as special work, as designing people know the importance of their work. Also it would be difficult for EPGL to find the other designing company, if there is conflict with first company.

IT & communication Setup-

Firm Specific knowledge- It is customised and continues service so the setup requires experts, who can bring about the changes as project develops. Also one who develops and setup the IT system knows all the key information and how to bring about the required changes Complexity of production- As it is very firm specific in terms of companys information and huge data. It requires huge time and continuous maintenance to keep the communication system working 24 /7. This makes the process complex. So it demands permanent expert who can deliver.

SecurityMonitoring Cost- EPGL has to monitor and make sure the work is carried by security guards honestly and in proper manner. Transaction Cost- It will be very high as the cost of finding the proper security agency will be added. Also the contract has to be renewed again and again as security service will be required till the running life of the plant. Also EPGL might have to enforce the agency to fulfil the requirements as the agency will try to get more pay by posting less number of security guards on the project field.

Work ForceFirm specific Knowledge5Project requires experienced and knowledgeable person to resolve issues rising during commissioning and completing the project on time. Monitoring cost- Sense of belongingness and loyalty will drive them to work properly avoiding the monitoring cost. As they would be capable of setting reporting systems, the management will be able to get updates on project progress.

5 - Essar Projects is uniquely positioned among the Indian contracting fraternity with its integrated
engineering, procurement, and construction (EPC) capability that includes both backward integration in steel and steel processing supply chain and forward integration of fabrication and modularization services. Apart from this we also have the advantages of incorporating operational experience of sister companies into the design and engineering phase of new projects.

Asset Specificity- Experienced work force is asset to the company. EPGL is utilizing the asset in order to establish new business by utilizing the knowledge of same work force. Analysis shows that firm is yet to reach the optimal vertical integration state. Below are the recommendations by which EPGL can have optimum utilization of resources and profitability.

Recommendation

Project Design- It should be in-house as it will reduce the

uncertainty and eliminate the scope for opportunities. It can deliver their services to upcoming projects. With less competition it will be easier to find business. With time it can be big and profitable business sector for ESSAR.6

Security- having their security EPGL would have more loyalty on

job and would need less supervision. Both regular and emergency situations could be manned easily. No monitoring costs as it will be one of the department of EPGL. Security is the first service which must be present from first day of project and 24 hrs.

Shipping- By using Essar shipping the company can reduce the

high transaction cost discussed above. It requires nearly 1 year for transporting project materials from China to India, comprising 80-90 trips. Also it can find more business during this time. This will eliminate scope for opportunism and uncertainty as EPGL will be at priority list. Most of the power projects coming up in India are importing project material from China. This creates the scope for shipping department to increase the business for long term and utilize the factors which is required to deliver the logistics services through sea route.

6 _ (The Indian federal government plans to set up 16 UMPPs (Ultra Mega Power Plants), each with
a minimum generating capacity of 4000MW, to meet the needs of the worlds fastest-growing major economy after China. Currently, India has a power generation capacity of 170,000MW and expects to add 62,374MW by 2012. As of November, 2010, 16 UMPPs have been planned in Karnataka, Chhattisgarh, Madhya Pradesh, Andhra Pradesh, Maharashtra, Orissa, Tamil Nadu, Gujarat and Jharkhand State. Source- Article India plans 16 Ultra Mega Power Projects to enhance power generation- Industrial fuels and power http://www.ifandp.com/article/0010818.html

References
Dr. Robert Hoffmann (2011)- Vertical Integration (Session 8) Sloman J. & Sutcliffe M. (2004)- Economics for Business (Third edition) Williamson O. & Winter S. (1993)- The Nature of the Firm (Oxford University Press) www.essar.com
http://www.oecd.org/dataoecd/39/15/40633690.pdf http://www.ifandp.com/article/0010818.html

Word Count- 2010