Globally, economists and lawmakers recognise price volatility of commodities as a key risk that can significantly affect economic activities that depend heavily on commodity inputs.
The ministry of power’s standard-form case-1 bid documents for power procurement by the state distribution utilities (Discoms) from coal-based power projects were issued in 2005. Various Discoms held competitive bids to procure power using these bid documents and winning bidders included Adani, Coastal Gujarat Power and Tata Power. Long-term power purchase agreements were executed between these power producers and the Discoms. Most of these bidders premised their bids on a mix of domestic and Indonesian coal in their power plants. Subsequently, the Indonesian government changed their domestic coal policy and benchmarked coal prices to prevailing international coal prices, negating any price negotiated in private contracts. This resulted in a steep rise in fuel costs and these power producers approached the Central Electricity Regulatory Commission (CERC) requesting a pass-through of the increased costs to the Discoms by increasing the tariffs. The CERC concluded that there was no provision under these power purchase agreements that allowed such pass-through of costs. However, given the severe impact of increased fuel costs on power producers, the CERC allowed them compensatory tariffs as relief. The CERC’s decision was appealed by the Discoms before the Appellate Tribunal for Electricity (APTEL).
The APTEL recently passed an order in this matter, which is a landmark judgement in a number of ways. As well explained by Ashwini Chitnis and Shantanu Dixit in an earlier article, the order is a good judgement as it upholds the sanctity of power purchase agreements and prevents the use of discretionary powers by the CERC to trump them. It also clears the air with respect to what actually should be or is the role of regulatory commissions in the context of competitive bidding regimes.
However, perhaps the more interesting feature of the order is the APTEL’s comment that “the statutory objective of electricity legislation in India is to not only protect the consumers’ interest but to also make electricity available at reasonable prices to ensure that the sector sustains itself on the returns it gets, because if the sector perishes, the consumer will suffer. Cheapest price is desirable but at the same time it must be reasonable and sustainable.”
This statement provides excellent guidance to policy makers, encouraging them to design competitive bidding regimes which balance risks and rewards amongst power producers, consumers and the government. A corollary to this is that if the bidders assume risks that are beyond their control when it is economically irrational for them to do, alarm bells should go off for the government. The design of the bid documents allowed bidders to take such economically irrational risks, leading to the problems that, in turn, led to the case being brought before the CERC in the first place. Let us see how this played out.
Long-term commodity price based contracts
Globally, economists and law makers recognise price volatility of commodities as a key risk which can significantly affect economic activities which depend heavily on commodity inputs. Consequently, the use of economic tools to protect against such price volatility, such as indexing commodity prices, passing-through variable costs and hedging the risk of increased costs in long-term commercial contracts, is common.
This is certainly the case where the economic activity in question involves the generation of electricity using fossil fuels. As we know, the supply and prices of fossil fuels are highly influenced by international political and economic events such as instability in West Asia, OPEC’s decisions with respect to oil supply and price and in the present context, the pushes and pulls of Indonesian domestic politics which led Indonesian coal prices being indexed to prevailing international coal prices. Therefore, in most countries, competitive bidding regimes awarding long-term power purchase agreements require bidders to quote escalable or variable fuel costs as part of their bids. Such escalation is usually linked to standard commodity market indices, which help ensure stability of returns on investment and a sustainable supply of power at reasonable prices. Bid documents may also specify a floor price, below which bidders are not allowed to quote their tariffs. These mechanisms prevent against aggressive bidding and the selection of bidders quoting tariffs which are, prima facie, likely to be unsustainable through the term of a 20-25 year power purchase agreement. Bids that are designed with such precautionary measures are more likely to result in contracts that achieve the balance between protecting consumers’ interest and ensuring reasonable returns on power producers’ investments, as alluded to in the APTEL judgement.
Where the Ministry of Power’s bid documents went wrong
In the Indian context, the 2005 bid documents gave bidders the option to quote either escalable or non-escalable fuel costs. To quote the cheapest price with the objective of winning the bid, power producers quoted aggressively, largely by opting for non-escalable fuel costs. The government, on its part, with the single-minded objective of procuring power at the cheapest price, regardless of whether such prices were sustainable or not, selected the lowest tariff. Subsequently, as mentioned above, the Indonesian fuel prices increased dramatically, leading to litigation with power producers pleading before the CERC to allow increased fuel costs to be passed through to consumers. There is no question that power producers are culpable for having exercised their choice to quote non-escalable fuel costs. Perhaps they felt that they would win the bid and come back to the counter-party i.e. the Discoms or the regulator and seek tariff escalation using, as in this case, force majeure or change in law provisions in the power purchase agreements. In that, APTEL is justified in having turned down their plea for compensatory tariff. However, with little more insight, it becomes clear that the bidding system itself had inherent deficiencies which offered the opportunity for it to be gamed.
Given that corporations operate on the theory of maximisation of profits and the government’s own experience in competitive bidding in the other sectors of the economy, by giving bidders the option to quote non-escalable fuel costs, the government either failed to apply its mind or was complicit in designing bid documents which they knew (or should have known) could be taken undue advantage of.
Partial correction, but lesson not fully learnt
The government did address the issue and the current version of the bid documents, issued in May 2015, provides for fuel costs to be passed through to the power purchaser and specifies a floor and ceiling on fuel costs that may be quoted by bidders as part of their bids. Also, the government has reserved its right to reject bids if the fuel costs quoted by a bidder are below the floor price. These are sensible steps.
There is however evidence that the government hasn’t learnt the wider lesson from the coal price fiasco – that competitive bidding has its limitations and may not always achieve the objective of low tariffs which are sustainable over the term of a 20-25 year power purchase agreement.
Consequently, history might be about to repeat itself with the current situation relating to competitive bidding in the solar power sector. In recent years this sector has witnessed increasingly aggressive bidding to the extent that solar tariffs have almost achieved parity with conventional power tariffs. Government appears to be euphoric about this achievement but without testing to see if such tariffs take into account the prevailing costs of solar power production or if they will deliver a reasonable rate of return to power producers on their investments. Analysts are therefore sceptical about whether some of these projects are capable of being financed and built.
There are ways to address this issue. First, as for the current bid documents for coal based power plants, the regulatory commissions could determine floor prices for solar power bids as well by considering the prevailing market prices of various tariff components. These floor prices could be revised in the future taking into account any decrease in capital costs and operations and maintenance expenses of solar power projects.
Second, as quite successfully in case of wind power projects, choose a feed-in tariff regime for solar power projects. As has happened in the wind sector, regulatory commissions are free to revise tariffs from time to time based on prevailing market conditions and commodity prices.
In any event, the government would be well-advised to account for the fact that slavish adherence to the competitive bidding mechanism may guarantee lower tariffs but may not guarantee that the underlying projects will be constructed and able to supply power on a sustained, long-term basis.