CAN ULTRA MEGA POWER PROJECTS RE-KINDLE U. S. INTEREST IN

UNCLAS SECTION 01 OF 05 MUMBAI 000077

SIPDIS

SENSITIVE
SIPDIS

DEPT OF ENERGY FOR COURTNEY GILLESPIE, MARK GINSBURG, TOM CUTLER, GIULIA BISCONTI, PDAS K.FREDRIKSEN
DEPT OF TREASURY FOR STEPHANIE SEGAL
DEPT OF COMMERCE FOR ART STERN
DEPT PLEASE PASS TO EXPORT IMPORT BANK FOR JESSICA FARMER AND RAY ELLIS
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DEPT PLEASE PASS TO EEB PETER HAYMOND AND BRENDA HAENDLER

E.O. 12958: N/A
TAGS: ENRG EINV ECON IN
SUBJECT: CAN ULTRA MEGA POWER PROJECTS RE-KINDLE U. S. INTEREST IN
POWER GENERATION IN INDIA?

REF: 2006 New Delhi 6313

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Summary: 1. (U) The Indian Power Ministry is touting the
attractiveness of ultra mega power projects (UMPPs) of 4,000 MW
of station capacity at a single location. The government is
taking the lead role in obtaining the necessary clearances,
land, domestic fuel linkages, and an assured market for these
projects to boost investor confidence and reduce risk
perception. Despite this, there has been muted foreign interest
in UMPPs. Our interlocutors engaged in the Indian power
industry cited payment security concerns as the main factor
deterring foreign participation in UMPPs. A relatively low
return on equity (ROE) on the projects, and imported coal
linkages, were other concerns cited as possible reasons for the
low foreign interest. Nitin Johar who works for Tata Power's
UMPP at Sasan dismissed many of these concerns. He pointed out
that UMPPs have three layers of payment security built into all
their power purchase agreements which assure prompt and regular
payment. He also claimed that the ROE from UMPPs is much higher
than commonly perceived. Despite Johar's claims, reported
problems at Reliance Power's Sasan UMPP will hardly inspire
global confidence to invest in an industry that is still haunted
by the Dabhol debacle. End Summary.

Power Shortages Compel Promotion of Large-scale Projects
--------------


2. (U) Currently, India has an installed capacity of 140,000 MW
of power. The country's per capita consumption of electricity
is around one-sixth of the world average. In addition, India
suffers from a 12 percent power shortage during peak hours and
analysts estimate that a doubling of power generation capacity
is needed within the next six years to sustain an annual GDP
growth rate of 7-8 percent.


3. (U) To address the country's crippling power shortages, the
federal Power Ministry has promoted large-scale power projects
of 4,000 MW station capacity at a single location. These ultra
mega power projects (UMPPs) are expected to generate cheaper
power of around three to four cents per kilowatt-hour as against
the current average cost of nearly seven cents per kilowatt-hour
of power. At the same time, they can meet the power
requirements of a number of states through the transmission of
generated power on regional and national power grids. Spread
across India, they will be located either at the pithead (near a
coal mine) of an assigned coal block, or along the coast to
facilitate easy coal imports.


4. (U) The UMPPs, implemented through
Public-Private-Partnerships, are to be awarded to a private
domestic or foreign developer through a tariff-based competitive
bidding process based on the lowest tariff quoted. The
government's initial participation in these projects is aimed at
enhancing investor confidence, reducing risk perception and
ensuring favorable private sector participation. In the
preliminary pre-bidding stage, shell companies formed to
implement the UMPPs work under the government-owned Power
Finance Corporation to obtain all clearances and will acquire
land for the project. Around 27 clearances are needed before a
power project can be commissioned. In addition, the shell
companies draw up power purchase agreements with the power
distribution licensees of the states that will procure power
from the completed projects. This ensures that the successful
bidder has an assured market to buy power at the tariff quoted.

Perception of Payment Risk Deters Foreign Investors, but UMPP
Operator Says Perception is Unjustified
--------------


5. (U) Power Ministry Director Sanjay Chadha, at a recent

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seminar in Mumbai, claimed that since UMPPs guarantee reliable
fuel supply, timely environmental clearances, and payment
security, foreign investors will flock to bid for the projects.
However, contrary to government expectations, there has been
limited foreign interest in these projects. So far, three UMPPs
of the planned 10 have been awarded and all have been secured by
private domestic companies. Tata Power was awarded the Mundra
project in Gujarat and Anil Ambani's Reliance Power secured the
Sasan project in Madhya Pradesh and the Krishnapatnam project in
Andhra Pradesh.


6. (SBU) Chetan Modi of Moody's who was earlier engaged in the
Indian power sector believes that foreign investors, haunted by
Dabhol, will never venture into the power sector in India. Most
power distribution companies who buy power are still state-owned
and operated, and are not financially sound, he continued. The
risk of payment default for power is therefore very high,
especially since the UMPPs are not backed by a sovereign
guarantee, Modi maintained. Ramya Venkataraman from McKinsey
pointed out that the federal government had helped state-owned
electricity boards pay off their outstanding dues to
government-owned National Thermal Power Corporation and Coal
India in 2000-01, even though it had not provided a sovereign
guarantee in these cases. Nitin Johar, the Associate Group
Head - Finance of the Coastal Gujarat Power (the company
implementing Tata Power's Mundra UMPP),stated that the federal
government will never guarantee any project after the Dabhol
controversy. Contradicting Modi's belief of a payment default
risk, Johar pointed out that the power distribution companies of
Gujarat, Maharashtra, Haryana, Punjab, Andhra Pradesh,
Karnataka, Chhattisgarh, Delhi, and Kerala, currently pay for
procured power on the first day of billing. He explained that
the power industry has an in-built reward system for timely
payment. State Electricity Boards (SEBs) and private power
distribution companies get a 2.25 percent discount on monthly
billing in case of early payment (before 30 days). This works
out to an annualized discount of 26 percent which is a
significant early payment incentive, he added. Power providers
are assured of prompt and timely payment and so are willing to
offer this monthly discount, he continued.

Three Layers of Payment Security Built into Power Purchase
Agreements
--------------


7. (U) Johar also explained that there are three layers of
payment security built into the power purchase agreements
between the UMPP provider and private or state-owned power
distribution licensees (procurement companies) of the states
buying power from the project. First, the power distribution
companies have to provide the UMPP provider with a rolling
letter of credit of 1.1 times the projected monthly billing. In
case the distribution company does not pay within 30 days, then
the UMPP provider can draw this letter of credit and secure
payment for the first month of payment default. There is also
an escrow account establishing irrevocable claim of receivables
of power distribution licensees, he continued. All incremental
receivables of these distribution companies over their operation
and maintenance costs, flow into this account and can be
accessed in case of a default. According to Johar, this default
escrow account mechanism blocks the company's cash flows and
"forces" them to pay. (Comment: The escrow account mechanism
enables a direct transfer of funds owed by the power procurement
company to the power provider. As the defaulting power
procurement company has no control over the escrow account, this
mechanism prevents a Dabhol-like situation from re-occurring
where the Maharashtra State Electricity Board refused to pay for
the Dabhol power. End Comment). Finally, if the owed dues are
not cleared within 90 days, the UMPP provider can sell 75

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percent of the electricity that is otherwise supplied to the
defaulting distribution licensee to third parties, including
industrial consumers. UMPP providers can sell this power at a
much higher tariff and can actually earn more money if the
default persists, Johar noted. Ron Somers, the President of the
U.S. Indian Business Council, said that while the open access
system of selling power to third parties looks good on paper, it
has never been tested. He also pointed out that the three-tier
payment security mechanism was implemented five years ago as
part of the electricity sector reforms implemented to attract
foreign investment, but foreign investors are still reluctant to
invest in this industry.


8. (SBU) In a separate discussion, McKinsey's Venkataraman
opined that the lack of foreign interest in UMPPs could be due
to a misapprehension about the project's payment security
mechanism. "The perception of payment risk may deter foreign
companies from bidding for UMPPs", she added. Venkataraman
agreed with Johar and claimed that domestic investors are
"comfortable" with the level of payment risk associated with all
power projects, not only UMPPs. Sunali Rohra of McKinsey
pointed out that while foreign companies are not bidding for
power projects, they are still investing in the Indian power
sector through infrastructure funds. So they are therefore
indirectly endorsing the viability of the project, she continued.

ROE, Imported Coal and Ambiguous PPAs Are Other Obstacles for
UMPP Investors
--------------


9. (SBU) Udai Kotak of Kotak Securities (no relation to the
company's founder) and Parag Baduni from IL&FS Investment
Managers believe that UMPPs offer a 14-15 percent return on
equity (ROE) (the after-tax profit of a company as a proportion
of its equity, expressed as a percentage). In contrast,
merchant power projects (MPPs) can earn a 20-22 percent ROE by
supplying power to the grid to meet peak load demand, they
noted. (Note: Merchant Power Plants are not tied to any power
purchase agreement. They compete for customers and absorb the
full market risk. In an energy deficient state, these MPPs can
sell power when demand is highest to earn high tariffs. End
Note). Johar however claimed that UMPPs can earn more than
14-15 percent ROE, which he points out is the assured return for
all negotiated power projects. He maintained that UMPP
providers take on more risk as the project is based on the
lowest tariff quoted as against other power projects where the
tariff is negotiated. As UMPPs assume greater risk, the rewards
necessarily have to be more than the assured ROE of 14-15
percent, he argued. (Comment: Although not explicitly stated,
Johar's remarks indicated that the ROE for Tata's Mundra UMPP is
estimated to be more than 14-15 percent. End Comment).
Operating MPPs have other risks like problems with coal
sourcing, infrequent operation as power is not supplied on a 24
hour basis, and transmission problems of connecting with the
power grid, Johar continued. McKinsey's Ventkataraman argued
that MPPs were "small play" and "serious" power companies would
prefer to venture into "big play" UMPPs.


10. (SBU) Kotak also noted that UMPPs run on imported coal need
to have a dedicated supply source of overseas coal. The price
of imported coal factored into the price tariff quoted at the
time of bidding for the project may be much lower that the price
of imported coal when the project is commissioned. Bidders for
UMPPs based on imported coal therefore have to tie up a reliable
coal source outside India before bidding to ensure a steady and
reliable coal supply, he continued. Many bidders are not
equipped to buy mines or mining leases overseas, he added.
Venkataraman concurred and added that if a bidder for an
imported-coal fuelled-UMPP did not have access to a coalfield

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and was dependent on the market price of coal, he was taking a
huge risk.


11. (SBU) Manjushree Ghodke, the Deputy General Manager
(Economic Cell) of Larsen & Toubro, stated that the
government-drafted agreements that form the basis of the
public-private-partnership for infrastructure projects,
including power projects, often lack clarity. These ambiguously
worded agreements fail to inspire investor confidence, she said,
and are responsible for the poor foreign participation in
infrastructure projects. She suggested that the government
appoint a legal consultant to draft these agreements to make
them user-friendly, clear and transparent.

Environmental Clearance, Land Acquisition Bog Down Sasan UMPP
--------------


12. (SBU) Johar told us that Tata's imported-coal based UMPP at
Mundra in Gujarat will be completed nearly one and a half years
ahead of schedule. Work has already started and the project
will be commissioned by March 2011 instead of the projected
August 2012, he continued. Reliance Energy's domestic-coal
based UMPP at Sasan in Madhya Pradesh has not met with similar
success. The project had to be re-bid after global investor
Globeleq Singapore exited and sold its stake in the project to
its co-partner Lanco Infratech. Anil Ambani's Reliance Power
matched Lanco Infratech's original quoted tariff and secured the
Sasan UMPP. Tata Power had also bid for the Sasan UMPP but
Johar stated that the winning tariff of INR 1.19 (around three
cents) was "unrealistic" and admitted that "Tata would never
have been able to match it." (Note: Johar believes that
Reliance Power had to secure the Sasan UMPP in order to obtain a
"high price" for its initial public offering. He claimed that
the IPO was over-priced and noted that Reliance Power's
projected energy capacity in 2012 will equal state-owned
National Thermal Power Corporations current installed capacity
and NTPC's shares are trading at around USD 5 as against
Reliance Power's IPO price of USD 11. End Note).


13. (SBU) The Sasan UMPP currently faces delays of
environmental and forest clearances, and problems with land
acquisition and allocation. Johar told us that the project is
located in the Singrauli coal belt of Madhya Pradesh where
National Thermal Power Corporation already has several large
power plants. Environmental clearance is subject to incremental
pollution caused by a new project, he pointed out, and the base
level of pollution is already high in Singrauli due to the
existing power plants in the area. Johar however believes that
land acquisition will be the bigger problem for the Sasan UMPP.
So far no land has been acquired and media reports state that
the government had even asked Reliance Power to reduce the land
required for the project. The government has touted the
attractiveness of UMPPs by claiming responsibility for acquiring
land and securing environmental clearances, but Johar admitted
that despite these assurances, procedural delays are quite
common.


U. S. Equipment Too Expensive, Chinese Equipment Not IP
Compliant or Without Adequate Capacity but Korean Equipment Just
Right
--------------


14. (SBU) Johar claimed that U. S. power equipment and
technology is too expensive and is therefore unlikely to be used
in a UMPP. Tata Power is utilizing Korean technology for its
Mundra UMPP. Venkataraman's McKinsey, said that many power
companies are considering using Chinese equipment for
non-critical components of the power plants. The move towards
made-in-China critical power equipment may take another 4-5

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years, she opined. Johar, however, claimed that most Chinese
power equipment suppliers were bound by technology transfer
agreements so any sale to companies outside China was an
intellectual property violation. To get around the technology
transfer agreement, these companies sell to Chinese shell
companies who in turn sell to Indian companies, he added. Johar
also noted that the Indian companies who buy from the shell
companies face a huge risk for if the shell companies are shut
down for any reason then there will be no one to service the
equipment and honor the contract. There are a few Chinese
companies who have their own technology but their equipment can
be used only in smaller 600 MW power plants, he continued. Tata
Power is considering using this equipment for their smaller
power projects but will not buy any "infringed" technology from
Chinese suppliers, he maintained.

Comment:
--------------


15. (SBU) Public-private partnerships in ultra mega power
projects were conceived to provide certainty to private
investors and to reduce risk perception. However, payment
security for these projects, a cornerstone of power sector
investment, still hinges on private and government-owned power
procuring companies of different states adhering to the power
purchase agreements signed with the private developer. U. S.
investors may be reluctant to place their faith on the
state-owned power procurement companies given the financial
crunch faced by most licensees and their poor track record
(Enron, GE, Bechtel with Dabhol, and AES with Orissa). Indian
energy players, however, appear quite comfortable with the
payment risk associated not only with UMPPs but all power
projects. The disparity between the two viewpoints indicates a
possible lack of understanding or misperception about the
current scenario in the Indian power sector and energy reforms
implemented since Dabhol. But as Tata Power Johar's said, you
have to be prepared to face Indian terms and conditions if you
want to invest in India. End Comment.
OWEN