Moral hazard from CERC ruling is a reflection of India's corporate culture

India's Central Electricity Regulatory Commission (CERC) has ruled in favor of a bailout to Adani Power for its 4260 MW UMPP to offset the losses on account of the unexpected increase in the prices of coal imported from Indonesia. It has agreed for a "compensatory tariff" to allow the developer to pass-through the fuel price increase.

In 2007, in a Case I bid, Adani Power had won the global bid to supply power to Gujarat Urja Vikas Nigam Lt (GUVNL), and in 2008 to Haryana's Uttar Haryana Bijli Vitaran Nigam Ltd (UHBVNL) and Dakshin Haryana Bijli Vitaran Nigam Ltd (DHBVNL). The PPAs signed with Gujarat government was to supply 1000 MW each at a levellized tariff of Rs 2.35 per unit and Rs 2.89 per unit respectively, and with Haryana government for 1424 MW at Rs 2.94 per unit. The buyers, Gujarat and Haryana, had refused to bear the fuel supply risk and offered the bidders the option to quote an "escalable" component to hedge fuel risk. But Adani, bidding aggressively, offered a nil tariff on this head.

The present problem arose when in 2010 the Indonesian government suddenly superseded all long-term coal export contracts and started levying higher royalty and taxes, reasoning that all exports should be bench-marked to international market rates. Many power generators in India, including Adani, Reliance Power and Tata for their UMPP, clearly overlooked this risk and bid aggressively offering very low levellized tariffs.

The CERC has now allowed Adani Power to temporarily charge a higher tariff but directed the generator and the buyer state governments to sit down and arrive at a mutually agreeable long-term tariff rate. The dissenting CERC member, Mr Jayaraman has raised several very valid issues in his dissent note. In this context, here are a few more observations

1. The moral hazard concerns arising from this decision are quite obvious. In this case, the developer clearly ignored the option of bidding with an "escalable" fuel price and bid very low with the intention of bagging the contract. It is not a stretch to believe that this aggressive bid was driven by the firm belief that they could re-negotiate their way out if the discounted risks surfaced. Clearly, the central principle of a transparent competitive bidding process was compromised. Whatever spin one gives it, the CERC ruling will only exacerbate the moral hazard. This becomes a matter of great concern given the large number of power and other infrastructure projects proposed to be contracted out to private developers.

2. As the financial market bailouts and the resultant "too-big-to-fail" problems among big banks in US indicates, bailouts can quickly transmit and entrench moral hazard risks that socialize private losses. In the circumstances, it is imperative that the Power Ministry and regulator step in with measures that will atleast partially mitigate the moral hazard risks. Apart from other measures, the only effective way in which such risks can be mitigated is by making the bidder internalize some share of the social cost inflicted by his irresponsible bid. The CERC order is conspicuously silent on this. Is the Rs 1350 Cr of loss apparently accumulated by Adani Power going to be the penalty? Or is there some definite amount of liquidated damages that will be imposed? Or should some share of the profits from the merchant power sales from Mundra now be ploughed back to re-compensate the PPA consumers? Whatever the penalty, it is important to specify it upfront, since it would carry considerable signalling effect on potential bidders and thereby contribute to mitigating the moral hazard unleashed.

3. The CERC directive to re-negotiate a mutually agreeable tariff is filled with several dangers. Discretionary decisions on such matters are very likely to benefit the private developer at the cost of the consumers. Since a number of other generators will now invoke the precedent to seek renegotiation for similar "compensatory tariffs", it is important that the CERC issue clear guidelines that guide any re-negotiation process.

4. Further, if it is a wholesale re-negotiation, then we need to explore a formal bankruptcy of the existing promoters. It may be even worth exploring the possibility that the project entity be taken into a form of temporary receivership and then ownership resolved through a formal process. After all the worst scenario from the moral hazard perspective would be for the project to be renegotiated on commercially attractive terms with the same developer who would escape with a small one-time penalty. That would be a recipe for similar irresponsibility in bidding and seriously undermine India's massive infrastructure investment ambitions.

5. This is a strong reminder on the need for adequately mitigating commercial risks on projects of such long-term nature and the adage that "risk allocation should be to those who can bear it best". In the euphoria surrounding PPPs, in the guise of aligning incentives, mainstream debates have encouraged governments to structure contracts in a manner that bundles such non-diversifiable risks on the private promoter. The private sector has most often played along, in the firm belief that they could escape through re-negotiations. Fuel price pass-through should be mandatory in all power generation contracts. Similarly, foreign exchange risks should be a mandatory pass-through in contracts with import requirements.

6. Another issue that needs to be examined is the contract based on which Adani Power purchases coal from Indonesia. This is because the Indonesian government order only says that exports can be done at international prices and does not expropriate foreign ownership of the mine. In other words, if the Adani Power has a 74% ownership of the mine, there is a strong possibility that, as the dissenting member in the CERC order wrote, "the Adani Group as a whole may be the ultimate beneficiary of the Indonesian regulations". In fact, as this Mint report writes, if we take a holistic view of the ownership of the coal mine and the power plant, the net cash flows would be affected only to the extent of additional royalty and tax payments.

7. Finally, this and others that I have blogged here, here, here, and here about recently are an accurate reflection of the irresponsible and even predatory nature of India's high-corporate culture. When they were formulated, the UMPP tender documents were acclaimed. It provided an elaborate formula, using a diverse basket of domestic and international indices, to allow the bidder to pass-through any increases in fuel prices. And, by allowing for both fuelprice escalation and fixed price bids, it followed the principles of a classic textbook bidding mechanism. In the circumstances, it is easy to blame the government, as is the wont now on anything, without shining the torchlight on corporate India.

Update 1 (5/4/2013)

As if to underline the issue of cross-ownership of mines and power company, Tata Power decided to transfer its 75% share in Indonesian mines to fully owned subsidiary Coastal Gujarat Power Ltd (CGPL), which runs the Mundra Project. This is to ensure that the cash flows of CGPL is not heavily squeezed by the tariff problem. In 2007, Tata Power had bought a 30% stake in Indonesian mining company PT Bumi Resources and inked long-term contracts for supply of coal to Mundra project.

It would have been logical to have the ownership integrated with CGPL from the beginning. But firms resort to such cross-holdings to minimize tax exposures as well as to maximize profitability of their investments. In the event of re-negotiations, it is important that all such cross-holdings be removed and costs internalized to the fullest extent possible.