The Coming "Power"-ful Collapse!!

Writing after a long time...but this is one topic which has almost picked up my hand and put it onto the keyboard to get it writing. The Indian stock market has had a great 2009 after a dramatic collapse in 2008. Things may not have improved as much as the market suggests there are not too many people who care for negatives when the market is going up at the rate at which is going right now.
The 2008 collapse started with the "Great" Reliance Power IPO in January. A company plans to put 28000 MW of power plants starting almost from scratch. It has no previous experience of putting up a power plant or running it. But if its coming from the most well known industrial family of India, then it has to be good. Or at least that was the perception. The IPO got subscribed in the first minute of opening and the Finance Minister commended it as a sign of the "Great Indian Growth Story". What happened later has become a part of stock market folklore and I will not repeat it here.
The hype around the "Great" entrepreneur of RPower is all but over, but it doesn't look like we are through with the whole "Power" story in India yet. The climax there is still awaited. And I am afraid it may turn out to be a disastrous anti-climax.
Almost every company (it doesn't matter whether it produces steel or anything else or nothing at all) has plans to put a power plant. The reason? Merchant power. The formula is pretty simple. Get your company a coal block allocation. Lets not delve into how that happens in India but anybody with sufficient "funding" should not have a problem with getting an allocation. Design a power project around that coal mine. The cost of producing power assuming 90% PLF etc. comes out to anywhere between 1 to 2 Rs depending upon how various assumptions change. Then project the selling price at 4.5 - 5 Rs. if not more and make an excel sheet, which will end up showing investors, bankers and shareholders an RoE of no less than 50%. Those number will make almost any investor salivate and then valuations go through the roof given that the company has "created" a goose which lays "Golden Eggs" (in this case "Powerful Eggs"), and of course, since the company has learnt lessons from the "Golden Goose" story, it is unlikely to kill it. So the company gets valued at 4,5,6 times its book value. The valuation could be higher, these are just indications. It looks like a win-win story. Investors are happy with the "excel sheet", bankers see the "Great Indian Power Deficit Story" (all stories in India are "Great") and see no problems in funding the Project at a nominal debt-to-equity ratio of 3:1 if not 4:1. Govt. is, of course, happy (but for the subsidies that it has to shell out). Consumers are happy because now there will be less load shedding and govt bears the cost of additional power through subsidies.So then where is the hitch?

Lets take the assumptions in the story one-by-one
1. Merchant Power @ 5 Rs.!!
For starters, merchant power is power produced which is not bound by a Power Purchase Agreement with a Fixed RoE. Given the power deficit situation in the country, merchant power sells at much higher realisations than what a normal Fixed RoE power purchase agreement would factor in. Given the fixed nature of costs, every additional paisa goes to the bottom line and RoE zooms. That is helped in no small manner by the 3:1 or 4:1 debt-to-equity ratio. The very fundamental question is how long will this merchant power rate sustain before the free markets take these heady RoEs down to reasonable levels?
Like all other commodities, power will also depend upon the classical demand-supply balance. Power, as a commodity has additional characteristic which not too many other commodities have. If not consumed, it perishes instantaneously.
Indian has been facing problems of power deficits for the last few years and it has only grown bigger with demand growth outpacing the capacity additions. (2008 was a particularly bad year for additions and the deficit galloped to unprecedented levels.) To encourage private power plants, Govt made the required regulatory changes to make it attractive for the private money to flow into the sector. The economics turned out attractive enough for private money to start pouring in. And it is still pouring in.
Now I think we have reached a point where all the "merchant" power plant companies will collectively kill the "Golden Goose". Have a look at the plans of Adani/Reliance/Sterlite/Jindals/Indiabulls/Lanco. I am mentioning only the big ones. There are lot many small ones, which will also add up to a quantum which will not be small in the scheme of things.
We are experiencing a peak hour power deficit of around 12-13000 MW. The power plans of the biggies total up to more than 30000 MW over the next 3-5 years. Of course, the demand will also go up, but I think this time around the tables are going to turn and the supply side growth is going to outpace the demand.
I have not included the plans of NTPC here. Have also not included anything on the Hydro or Renewable front.
Just to give you a sense of what might happen. According to CEA, in 2007-08, there was about 13000 MW of gas-based power capacity which was running at 50% PLF simply because gas was not available. There is another 1100 MW which never got commissioned because of gas shortage again. Now with Reliance coming out with gas from KG D-6 and other discoveries still pouring in, there is a good chance that these power plants will start running full steam. That alone will increase supply by 4000-5000 MW. That's almost half the deficit we are talking about.
2. The other thing about the deficit is that it is "peak" deficit. Every body talks about the load shedding across various parts of the country as an indication of how big the power problem in the country is. But the point to be noticed is that most of the load shedding happens in the peak utilisation hours of the day. i.e. somewhere between 9 AM and 5 PM. What is consumed in the remaining part of the day is the roughly equal to the base load and the deficit there is not so huge.
So is it reasonable to assume 5 Rs of power for whole of 24 hours.?? I don't think so. In fact if trends on Indian Energy Exchange is anything to go by, the difference between the power rates for these two different time periods of the day has already become substantial. For quite a few days now the off-peak hours merchant power is trading at well below 2 Rs. The reason I would think is that in the race to take advantage of the "Peak" power deficit the power producers have started to overwhelm the off-peak demand and are unable to sell everything at peak rates. Even the peak rates which used to hover around the double digit mark a year back have come down to 5 Rupee levels. (I am using the IEX as indicator of merchant power rates in the day-ahead market)
The base load demand wil probably grow in conjunction with GDP. It should majorly depend upon how deep has the T&D network spread. Distribution is mostly in the hands loss making SEBs (Last year all SEBs put together lost 31000 cr., if subsidies provided by the govt. are included it comes down to probably somewhere around 12000 cr.) . That makes it difficult to for these SEBs to keep putting up additional distribution capacities "fast enough".They necessarily have to be supported by Govt deficits which are already out-of-control.
So here we have a value chain in the overall power business, where the power generators are hoping to make 50% RoEs and their clients (SEBs) are in perennial loss making mode. How long this can sustain is any body's guess.
3. One of the reasons for the losses of the SEBs are the famous (or should I say "Great") T&D losses. They are at about 30%. Even a 5% saving on this front can cut the "peak" deficit by half. I don't have great hopes here, but have just presented it as a scenario.

The Golden Goose story has twisted slightly. The fate of the owners will probably be the same. Just that they are not going to kill their own goose but may collectively kill each others.
I wont be surprised, if some time in 2010 or 2011, the merchant power rates collapse and everybody starts running for cover. Beware Bankers!!

Awaiting the "Power"-ful Collapse!!

(I don't claim to be the know-all in this business. These are just my thoughts. and I retain my right to be absolutely wrong)