Modi Government's Most Critical Power Sector Reform Takes Shape
UDAY seems to be a well thought-out, scalable, future proof-reform and restructuring programme for the struggling power distribution companies.
The Modi government has viewed power for all, potentially 24×7, as an electoral asset with respect to the 2019 reelection campaign. Swarajya first covered this possibility earlier this year, and then also outlined how the power distribution companies or discoms held the key to delivering this promise.
Almost a year after the Minister of State with independent charge for Power, Coal and New & Renewable Energy Mr. Piyush Goyal worked to solve the issue of coal block allocations and creating coal linkages to support long term fuel availability, the discoms have got their own revival programme. Named UDAY or Ujwal Discom Assurance Yojana, the programme was announced by Mr. Goyal on November 5th after a series of extensive consultations with state governments – Chief Ministers, Power Ministers, and various bureaucrats, to get them onboard with respect to this transformation plan.
After the 2003 Electricity Act was passed by the Vajpayee government, the discoms were carved out of the monolithic state electricity boards across India at varying speed and efficiency. This last mile aspect of the power sector never had any central control given that electricity is an area of concurrent list in India. Since their creation, state governments running the discoms have routinely attempted to rope the central governments to underwrite their operational inefficiencies, given the importance of power supply as an instrument of politics. Twice the central governments have attempted to clean up the poor management of state discoms and both attempts were a failure.
The first one came right at the time of generation, transmission and distribution functions decoupling which happened in the Vajpayee era. The second attempt was made by the UPA-2 government in 2012, via Financial Restructuring Plan or FRP. Both the plans focused largely on capital infusion into discoms, but like black holes absorbing all mass coming towards them, discoms continued to burn all cash thrown at them without turning profitable.
Post the failure of the 2012 FRP, the discoms have continued to borrow from public sector banks (PSBs) and other financing entities like Rural Electrification Corporation (REC) and Power Finance Corporation (PFC). By March 2015, the discoms had an outstanding debt of ₹4.3 lakh crores, accumulated losses of ₹3.8 lakh crores, and they added ₹60,000 crore of fresh losses just in the last financial year. Of this huge accumulated loss, just eight states account for 75% of the total loss.
These include Andhra Pradesh, Haryana, Madhya Pradesh, Punjab, Telangana, Rajasthan, Tamil Nadu and Uttar Pradesh. PSBs have been lending to the discoms with the assumption that the state governments implicitly backs them. But several discoms fail to cover even then operational costs, not to even talk about servicing debt – their cost coverage ratio (CCR) or costs of operations covered by revenue generated is less than 1. This situation is akin to the position of several e-commerce players in India where every time the company sells more goods, its losses widen.
Unfortunately for discoms, they are backed by debt from the crippled PSBs, which are under tremendous asset quality pressure and not by VCs from Silicon Valley who are willing to expand equity funding in the hope of future profits and hence valuations.
So how will UDAY ensure India achieves the dream of 24×7 power and power to all in the next few years given the magnitude of the problems?
While there is nothing certain in a democracy laced with electoral populism and constantly edgy centre-state relations, this plan may well be the “now or never” stage for discom revival. UDAY addresses a range of issues rather than doling out cash and hope things will improve operationally. It is broad-based and comprehensive, “ready for future” and agreed in principle by the states. These factors make this plan different from the previous two attempts.
Financial Restructuring, Not a Bailout
UDAY is not a simple central government driven bailout programme which just gives cash to discoms and states without accountability. There’s a specific roadmap for debt restructuring and there are hard budget constraints imposed for participating in the programme. Once on board, the states will not be able to back out and the only prudent course of action for them will be to keep their side of the bargain – which is around driving operational efficiencies.
The centre is allowing states to relax their Financial Responsibility and Budget Management (FRBM) Act 2003, another cornerstone of India’s fiscal management carved out by the Vajpayee government – which limits states’ ability to embrace populism when balancing their books. Under UDAY, participating states will take over their public discom (private discoms are not allowed to participate in the programme) debt over two years with the debt benchmarked to September 2015. In 2015-16, they can take over 50% and in 2016-17 25% of the outstanding debt on their books.
The centre will exempt the principal component of this debt from the FRBM limits for certain duration for each state. The interest payments however will have to follow FRBM limits – ensuring that the states cut back elsewhere on unnecessary expenditure to not default on their interest payments. The principal component will have a maximum of five-year moratorium on payment – so the states can over time find ways to retire debt.
This restructuring has two important effects. Firstly, although discoms debts are “deemed state government borrowings”, they actually pay more interest to borrow from the market compared to what a state government will pay. This is worst of both worlds – the market believes discoms will never default, while giving no interest rate benefits for not doing so. If the debt is on state government books, the interest rates can easily be 4%-5% lower than what discoms pay, in some cases even as much as 6% lower.
As part of this loan book transfer, the states will give a “one time grant” to discoms to pay off their existing debts to the lenders. Simultaneously, the states will then issue new bonds against this debt – at an interest rate 4%-6% lower than what discoms were paying. This is a significant step not just for the discoms, but also for the stressed banks. Their existing loans get paid off – a huge positive impact on their dire provisioning situation and reducing their stressed assets, and they become free to redirect the loans to these newly issued state government bonds – which are safer being “deemed sovereigns”.
This will have a big collateral impact on the country’s banking system – not in the remit of power ministry by definition, but nonetheless a big contribution. The bonds floated by states to cover these loans can be sold in the market as safe investment instruments to domestic and foreign institutional investors, or to investment funds including mutual funds, or of course to the government entities like LIC or the PSBs. Although the centre cannot commit, it is clear that in the event of a low-market takeoff, the finance ministry will definitely step in to ensure these bonds are subscribed via government financial institutions. Also the PSBs will move away from the current situation of shouldering 100% of the lending burden to discoms via this bond issue arrangement.
Another great point about this plan with respect to the banks is that these state government bonds cannot be counted against banks’ statutory liquidity ratio (SLR) requirements – presumably the RBI was roped in for this provision already. While this will classify these bonds as state development loans (SDLs) available for sale in the bank books – currently overwhelmed by similar securities – over time, they can create a tradable market in these securities. This can be a good template for future, with a degree of market tempering built into what the discoms can borrow.
The part of the discom loan that the state does not take over – the 25% outstanding – will also undergo a financial restructuring with the state governments explicitly underwriting this portion. Banks will then reduce their rate of interest on this component as well for the discoms.
The most significant part of the financial package is that in future, no discoms can borrow more than 25% of their last year’s revenue against their working capital requirements. This means that they will be pushed to generate enough cash from their business to keep funding their operational expenditure. This is a long term provision, but will be built in the initial MOU that onboards the discoms on to the UDAY package. RBI has already issued guidelines for banks to stop lending to discoms at certain threshold limits – which will then force discoms to improve operational efficiencies.
Value Chain View
Indian power sector has a very complex value chain – which involves fuel, fuel linkages, power generation, power transmission, power trading and financing, distribution, and end consumption. Different steps in the chain are owned by different parts of the central and/or state governments. UDAY ensures that the discom reforms are not just distribution centric, but positively impact various inputs and outputs to the distribution function, even those which are not owned by the centre directly. This is a big positive vis-à-vis the past discom reform packages.
On the transmission side which is the input to discoms, the central government has launched two big centrally sponsored schemes – Deendayal Upadhyay Gram Jyoti Yojana focusing on rural electrification infrastructure and the Integrated Power Development Scheme for urban areas. These schemes aim at improving grid infrastructure, transformers and cables, grid interoperability, transmission standards unification, smart metering, and improved measurements of payment dues among other things. The states which opt for UDAY and improve on their operational parameters will be given increased grants via these two schemes to create a better state level infrastructure.
The central government will take a discretionary call on budget allocations based on performance on UDAY parameters, thus creating a positive reinforcement loop – better infrastructure will further aid operational improvements. These schemes are investing in real, high-impact areas like compulsory feeder and distribution transformer metering by states, separation of agricultural feeders, consumer indexing and GIS mapping of revenue losses. Each state stands to gain more if it does more from its own side.
There’s also better demand side management being driven by the central government, which is the output of discoms. The government is currently running a plan to increase adoption of LEDs throughout India, which has been a big success. 7 cities in India have completely replaced their street lights by LEDs and another 78 are working towards it. By 2018, 77 crore bulbs in the country will be replaced by LEDs, and right now, several discoms allow consumers to take 4 LEDs at a nominal charge after registering on an online portal. LEDs consume lesser power and provide better illumination and once the 2018 targets are met, the peak load is expected to reduce by 20 GW. This LED push has already resulted in a retail price crash over the last year from an average of ₹600 per bulb to ₹350 per bulb. The central government is also pushing for better agricultural pumps and appliances like fans and air conditioners.
If the demand side is better managed, it will reduce the power requirement itself, and the excess can then be diverted for non-domestic consumers like industrial units, railways and agriculture. This will reduce dependence on diesel pumps and inverters, which are an integral part today of any industrial or agricultural operation in India.
Operational Efficiency Focus
UDAY compels the discoms to improve operational efficiency. The financial restructuring package will be based on a loss trajectory agreement where the discoms will sign up for ensuring their cost of operations reduces and their revenue from operations is sufficient to cover their cost of supplies.
The biggest issue to address in this space is the euphemistic Aggregate Technical & Commercial (AT&C) losses. These losses include a range of things – theft, people not paying for electricity running up outstanding bills, tampered meters, free power doled out by politicians at the drop of a hat, and of course real transmission losses which cannot be technically avoided. Several states in India run huge AT&C losses – Bihar 46%, Jharkhand 42%, Odisha 39%, Haryana 34%, West Bengal 32%, and Madhya Pradesh 28% lead the dubious pack, not counting the hilly regions of North and North East. This is essentially a law and order and enforcement problem more than anything else – contrasted by the disciplined operations in Goa 11%, Delhi 14%, Maharashtra 14%, Himachal Pradesh 15%, Gujarat 16%, and Kerala 16%.
The UDAY package will need the states to bring their AT&C losses to 10% or 15% (customized for each state) by 2018-19. This is a huge ask, but if the states achieve this, they will get the additional benefits of better infrastructure and technology via the centrally sponsored schemes. The central government will be monitoring the progress on this parameter regularly – a clause built in the UDAY MOU. Rajasthan which has been blazing a reform trail of its own may well be the first state to commit to hard AT&C control targets – the state is considering monitoring these losses not for the state as a whole, but at circle level – for better accountability of individuals in the state electricity board.
The action on this count by the states will be the single biggest driver towards the “power on tap” dream – and for the first time, there will be carrots and sticks for the states to act on this. Even if the bigger culprit states get in the region of 20% AT&C losses in the next 4 years, it will move the needle significantly.
The central government has even promised legislative changes required to ensure consumers choose their discom and switch, letting multiple discoms operate in the same region. This will require amendments to the Electricity Act, so the enforcement may be delayed, but even talking about separating content from carriage and encouraging last mile competition is a bold move given the state of the power sector today.
Given that several states have own captive power plants or want energy security in terms of generation capacity, UDAY will address operational bottlenecks even on the generation side. The plan provides for easier transferring coal linkages from old to more modern plants, and incentives for creating large plants running at an economy of scale rather than operating small sub 200 MW plants. Additionally, UDAY will involve incentivizing 11 top industries which consume almost 50% of all industrial power to improve their operations.
No Tariff Pressure
The conventional wisdom in the power sector has been that discoms need to keep increasing tariffs for end consumers indefinitely. This approach essentially rewards those who cheat and don’t pay bills indulging in theft and pilferage on the cost of those sticking to their payment obligations. This approach also does not incentivize any operational improvement for discoms, which are happy to petition for higher tariff orders to state electricity regulatory commissions (SERC).
UDAY ensures that no operational inefficiencies can be passed on to the end consumers. The first step is to reduce waste from the system and do a direct pass through of all benefits to the consumers. The state of Maharashtra actually reduced its industrial tariffs by ₹1 per unit earlier this year committing itself to making up via improving systemic inefficiencies. This same approach is possible simply by acting on AT&C losses – this is the power which is available but not being monetized. If a state improves AT&C losses by 10%, it can provide power to more consumers at the same rate or more power to the same consumers while getting paid for it.
The legislative action that will back UDAY will ensure that the SERCs do not approve tariff hikes without the discom traversing the agreed improvement trajectory. This will also force the discoms to act on internal processes rather than look at the regulator to help them out every time there is a financial crisis. This approach will increase the professionalism in the sector over time.
Focus on Renewable Energy
As part of the 2012 FRP, discoms had signed up for a Renewables Purchase Obligation (RPO), which then was never enforced as the FRP itself fell apart. UDAY brings back the focus on this RPO again, although no dates are mandated. This is a significant step especially in light of the recent Sun Edison bid for an Andhra Pradesh solar power plant at sub ₹5 / unit. If discoms start mandating purchase via renewable sources as per their respective RPOs, it will give a big boost to the renewable sector.
The financial restructuring plan will free up lending capacity for banks and other financial institutions for the renewable generation players. And because the discom side will now be guaranteed by state governments, there can be a virtuous cycle over time favoring big leap for renewable energy.
As of now, the central government has not specified the modus operandi of the RPO enforcement. However given that the government has otherwise set a target of 175 GW of renewable energy generation by 2022, there will definitely be some movement on this aspect sooner than later.
Centre No Longer Knows Best
The power sector reforms have traditionally been marred by the “centre knows best” approach. UDAY however creates enabling provisions across the power value chain for states to choose and do what fits them, with the view of reaching the committed operational goals. There are incentives at various stages of the value chain, and each state will find value in choosing different paths and different speeds of implementation. The only binding part will be reducing the AT&C losses i.e. improving the law and order situation enough to ensure there is no pilferage.
UDAY will come into force via a tripartite MOU between the Ministry of Power, the state government, and the state discom. The clauses will be binding on all three parties creating the right stake in the game, focus on measurements, and incentives for doing the right things. Mr. Goyal has already promised kicking in the changes via the BJP ruled states – an excellent move which will create examples to emulate for other states. An interesting first start has been made by Haryana for providing unimpeded rural electricity via Jagmag Gaon program:
Yes – the states can still mar the program. India is never too far from a populist electoral campaign promising free power to farmers, or parties asking consumers not to pay their electricity bills, or consumers tampering with electricity meters with no law and order control. But since 2013 December assembly elections, more and more election campaigns are moving towards a development and outcomes plank, rather than identity or inputs plank. Hopefully the democratic process will provide enough incentives for politicians to not wreck the boat.
UDAY is a well thought out, scalable and future proof reform and restructuring program. It creates an actionable roadmap for each discom to become profitable over the next 5 years, while cushioning the financial pain by reducing cost of financing and cost of operations. The program puts in place the right incentives for state governments to act in good faith towards cooperating with the central government and jointly achieving the stated targets. Mr. Goyal has worked closely with all the states to get them onboard this program, and in the spirit of the country’s federal structure – providing fair terms and conditions in lieu of signed up improvements.
For an 18 month old government, eager to demonstrate that its policy announcements can be translated to operational changes, UDAY comes in as a shot in the arm. Starting Q1 2016, there will be visible action every day, as discom loans get restructured and transferred and as states reach out in the market to sell their bonds, testing their credibility and putting their reputation on the line.
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