Crucial Ruling

Decoding the Supreme Court order on compensatory tariffs

In a recent order, the Supreme Court has set aside an earlier order by the Appellate Tribunal for Electricity (APTEL) that allowed Tata Power and Adani Power Limited (APL) to charge compensatory tariffs from offtaking utilities. The order is being seen as important as it not just affects the viability of the two companies’ projects, but also has significant ramifications for the power sector as a whole. While it has raised questions for a number of other competitively bid projects that were seeking a similar tariff review due to under-recoveries, it will also change the bidding strategies for future competitively bid projects. Sector experts comment on the Supreme Court order and discuss its overall impact….

What are the key takeaways from the SC order on the compensatory tariff case for the power sector?

Gurpreet Chugh, Consulting Director, ICF International

Gurpreet Chugh

This is a crucial judgment that will be used as a citation for future cases. The key takeaway is that the SC is going by what is allowed as per the written contract and not treating change in foreign law as force majeure, while APTEL took a different view of this issue.

 

 

 

Ashok Khurana

The SC was seized with four issues:

  • Tariff revision due to the impact of a change in Indonesian regulations;
  • Tariff revision due to a change in the National Coal Distribution Policy (NCDP) on account of the
    Ashok Khurana, Director General, Association of Power Producers

    inability of Coal India Limited (CIL) to meet its commitment to supply the annual contracted coal quantity;

  • Jurisdictional issue regarding a developer having multi-state power purchase agreements (PPAs), that is, the developer needs to approach different states with which they have PPAs or can approach the Central Electricity Regulatory Commission (CERC), treating the PPAs as a composite tariff scheme; and
  • Can the CERC exercise its residual power under Section 79 to review/modify the tariffs adopted under Section 63, in accordance with the guidelines issued by the centre or otherwise?

The Supreme Court held that no relief can be given under either the “change in law” or “force majeure” clauses for impact on tariffs due to a change in Indonesian regulations. However, by agreeing to the CERC’s residual power to review tariffs under Section 79, the SC has kept the door ajar for a corrective mechanism through the policy framework. Accordingly, backed by a suitable policy framework (similar to what was done in the case of domestic coal scarcity), relief on the ground of “commercial impossibility” of a contract, a well-accepted principle in regulatory jurisprudence, can be considered by the CERC under Section 79(1)(b). There is no doubt that in the absence of policy/regulatory intervention, these projects would need to be mothballed, adding to the stock of progressively increasing non-performing assets (NPAs) in the sector. Another compelling argument in favour of policy/regulatory intervention is that even after the proposed increase in tariffs as decided by the CERC, the procurers will get power from these two projects at a substantially lower cost than the current long-term market price, as evident from the bids received in the last round of bidding. The change in the NCDP, followed by the Government of India’s advisory, was held to be a change in law, thus setting aside the CERC order in a recent case. This ruling has helped clear the uncertainty regarding the impact of policy changes on tariff post bidding by the state or its instrumentalities, for example, a surcharge or increase in other levies by the railways/CIL, or modifications to be undertaken by projects to meet the new environmental guidelines. The Supreme Court also upheld the validity of the composite tariff scheme for multi-state PPAs.

Sabyasachi Majumdar, Senior Vice-President, ICRA

Sabyasachi Majumdar

The Supreme Court, in its order dated April 11, 2017, noted that the change in international regulations would not be construed as a change in law or a force majeure event with respect to PPAs signed with the distribution utilities. In ICRA’s view, the SC order is a negative development for APL and Coastal Gujarat Power Limited (CGPL), as well as other imported coal-based project developers with an aggregate PPA capacity of about 9 GW, which is competitively bid based with either nil or a limited fuel escalation clause in the tariff. As a result, the ability of the affected IPPs to optimise their fuel cost through the use of low-calorific value coal, as well as to improve the operational efficiency remains critical. Further, the extent of the negative impact would vary among the affected entities and will depend on the cash flow benefit available from the ownership of overseas coal mining projects. In this order, the SC has further directed the CERC to review and determine the relief that can be granted to power generation projects affected by changes in law under Indian conditions. This, in turn, is a positive development for power projects having an aggregate PPA capacity of 10 GW, which have been affected by a shortfall in the supply of domestic coal by CIL, leading to dependence on costlier imports till 2014-15.

However, the timelines for the implementation of such relief remain unclear, given that the overall progress in the resolution of tariff compensation even under change in law has remained very slow with offtakers contesting the orders passed by the CERC/state electricity regulatory commissions (SERCs). In addition to the under-recovery of energy charges, many recently commissioned and under-construction projects with competitively bid-based PPAs remain exposed to the risk of under-recovery of fixed charges because of the significant increase in capital costs following delays in execution, exchange rate volatility and funding problems, coupled with the non-escalable (fixed) or limited escalable (indexed) nature of the competitively bid-based tariffs. From the perspective of the distribution utilities, the Supreme Court order is favourable for them given that the utilities in Gujarat, Haryana, Rajasthan, Maharashtra and Punjab would continue to receive power at the contracted tariffs from the projects of APL and CGPL. However, any relief approved for power generation projects affected by changes in law in Indian conditions would increase the cost of power procurement for the offtaking utilities to some extent. Consequently, timely pass-through of the additional cost under the fuel and power purchase cost adjustment framework remains important for the utilities from their cash flow perspective.

Padam Prakash, Director, Power & Utilities, PwC

Padam Prakash

The Supreme Court’s judgment of April 11, 2017, dealing with the matter of compensatory tariff, has clarified several issues pertaining to power procurement by distribution licensees under Section 63 (determination of tariff by bidding process) of the Electricity Act, 2003. The Supreme Court, vide this judgment, has interpretated several sections of the Electricity Act, 2003, provisions of guidelines issued by the central government under Section 63 of the act and the PPAs forming a part of the standard bidding documents issued by the central government as mentioned below:

  • Applicablity of Section 79 of the Electricity Act in the case of power procurement under the competitive bidding process: Section 79 of the Electricity Act provides the central commission with power to regulate the tariff of generating companies. It is clarified in the judgment that regulating tariffs includes determination of tariff under Section 62 of the Electricity Act and also adoption of tariff under Section 63 of the act. In case the guidelines issued by the central government do not deal with a given situation, the powers provided under Section 79 can be excercised by the central commission. In other cases, the central commission is bound by the provisions of the guidelines.
  • Jurisdiction of the central commission: It is interpreted by the court that in case the generation and sale takes place in more than one state, the central commission will become the appropriate commission under the Electricity Act. The state commission, having jurisdication in respect of the licensee who intends to distribute electricity and make payment, will be considered an appropriate commission in the case of interstate supply of electricity, only if the concerned parties make an application in this regard. In other cases, the jurisdiction is with the central commission.
  • Applicability of force majeure clause: The unexpected rise in the price of coal will not be treated as a force majeure event as it is clearly mentioned under Clause 12.4 of the PPA. Therefore, no relief can be granted on this account.
  • Change in law: The judgment has made it clear that the change in the law of Indonesia would not qualify as a change in the law under the PPA and the guidelines issued by the central government under Section 63 of the Electricty Act. However, the reduction in the supply of coal from CIL and other sources in India, compared to the quantum mentioned in the fuel supply agreement, would be treated as a change in law for the purpose of compensating the increase in costs associated with sourcing coal from alternative sources.

The above interpretations by the Supreme Court have made it clear that the provisions of the PPAs and guidelines issued by the central government under Section 63 of the Electricty Act will have a superseding effect over the regulatory powers provided to the regulatory commission under Section 79/86 of the Electricty Act. In other words, a commission can use its regulatory power to modify the tariff discovered through bidding only in accordance with the provisions of the guidelines and the PPA and when the provisions of the PPA are not clear.

The ambiguity with respect to change in law pertaining to a foreign country from where the fuel is imported and the treatment of escalations in fuel price as a force majeure event has been eliminated. It is also established that an increase in fuel prices or change in law in a foreign land cannot lead to the PPA being thwarted. The obligation of fulfilling the contract (PPA) cannot be relieved due to these events. The judgment will also impact several other PPAs signed through competitive bidding. The judgment has significantly restricted the impact of power tariffs on consumers and supported distribution utility finances.

Mohit Saraf, Senior Partner, Luthra & Luthra Law Offices

Mohit Saraf

The key takeaway from the Supreme Court’s judgment is that developers and regulators must follow the rule book. As per the rulebook, the contract on the basis of which a project is awarded is binding under all conditions. Further, since the contract did not have any provision under which the regulators could grant compensatory tariffs, the earlier orders (passed by the CERC and APTEL) were set aside by the SC. The regulators had passed favourable orders in the past in order to support the power sector’s growth but those lacked any legal basis.

I feel the bidding conditions were faulty in the first place and a mature policymaker should not ask the developer to underwrite fuel prices. But a key takeaway from the apex court’s judgment is that when developers bid on the basis of a contractual document, they have to abide by the contract’s terms and conditions, irrespective of how harsh they are. The judgment implied that if developers bid irresponsibly in order to secure a project, then they should pay the price for it.

How will the order impact the future bidding strategies of thermal power producers?

Gurpreet Chugh

One key impact will be that the bidders will be much more careful in bidding for long-term fixed tariffs when the fuel price risk is not fully mitigated. Meanwhile, power procurers need to learn not to design bids that encourage fixed tariffs for uncertainly long periods and push unwanted risks onto investors. If investors take such risks, a risk premium will get factored into the bid. Any deal bid design allows the developer to always remain profitable and viable so that the project keeps on operating and does not get stranded. For developers, the project returns will be impacted, which may even erode the equity value of the project. This exposes the project to the risk that once the equity is eroded, there is no incentive for the developer to operate. This risk can be further passed on to the debt providers if the asset is stranded.

Ashok Khurana

The fact that no prudent developer can take an appropriate call on the movement of commodity prices, foreign exchange, interest rates or risks of certain events (which are beyond contemplation) for a period as long as 30 years implies that we need to reconsider the design of long-term infrastructure contracts to provide for a mechanism to introduce necessary modifications to meet such situations. Fortunately, the revised documents take care of fuel price risk, but there are still many other risks over which a developer has no control, but documents in their present form expect the developer to factor those risks in its price in essence, “to speculate”. These flawed provisions too need reconsideration to ensure competitive and sustainable price discovery.

Sabyasachi Majumdar

The future bidding strategy for thermal power producers is likely to be cautious with greater focus on cost-reflective tariff bidding rather than aggressive bidding to win projects. In the past, various project proponents had taken risks (particularly related to exchange rate and fuel price) in the bidding rounds that took place between 2005-06 and 2010-11 for award of thermal projects. Nonetheless, there has not been any bidding activity for the award of long-term PPAs by state-owned distribution utilities in the past two years. This is also a result of a significant improvement in the overall energy availability led by capacity addition, though energy demand growth has been subdued. In turn, utilities continue to prefer procurement for any shortfall in energy requirement through the short-term market, where tariffs have declined substantially.

Padam Prakash

The clarity provided by the SC will have a positive impact on the bidding for future projects under the competitive bidding process. The intent of the court to hold bidders and lenders accountable for the risks that they had willingly assumed at the time of bidding will not discourage aggressive bidding for future projects. In the future, thermal power producers will not rely on any strategy that is based on a post-bidding increase in tariffs. Bidders will carry out a detailed assessment of all the potential risks. The focus of bidders will be on quantifying the implication of these potential risks and incorporating the same in the financial bids. A more logical allocation of fuel charges between the escalable (fixed) and non-escalable (indexed) components can be expected in future bids. The objective will shift from winning the contract at an aggressive price to getting into a commercially sustainable contract. It will not only help the power sector to operate on sustainable and commercially viable principles but will also lead to more realistic tariff discovery for future projects.

Mohit Saraf

The SC judgment will set a precedent for establishing a strong contractual framework in the power sector. It will also drive international investors to participate in future bidding rounds. In the 1990s, when the power sector opened up, many international players were keen to be a part of it, but they all pulled out gradually due to inappropriate risk allocation in the bidding documents. Domestic players, however, continued by undertaking aggressive and irresponsible bidding. Due to such reckless bidding, the power sector has one of the largest shares in NPAs of banks today, as bidders are not in a position to service their debt with their existing cash flows. With the SC judgment, developers are likely to take all aspects into account before submitting their bids. They cannot seek changes in the contract post the award of the project. This will increase transparency in the contractual framework, thereby attracting global players in future bidding rounds.

GET ACCESS TO OUR ARTICLES

Enter your email address