Private equity investments in hydro-electric plants in Himachal Pradesh are highlighting the appeal of small-scale power projects

In October last year, a US-based private equity fund poured US$25 million into two small hydro-electric power projects (SHPs) in Himachal Pradesh. The deal was the latest in a string of similar transactions which signals a move by power-sector investors away from the mega-projects of yesteryear towards smaller, more environmentally sustainable opportunities.

The private equity investor, which cannot be named for confidentiality reasons, acquired a 49% stake in two Indian companies, each of which holds a licence to generate electricity in the state. The shares were acquired by a Mauritius-based special purpose vehicle, itself a wholly owned subsidiary of a holding company in Delaware, which had been incorporated by the private equity investor specifically for the transaction.

Differential and affirmative voting rights were employed in the Indian entities’ shareholder agreements in order to provide the private equity investor with a high degree of control. The investor also took a majority of seats on the boards of both Indian investee companies.

Powerful potential

Himachal Pradesh, the mountainous northern state in which both of the investments were made, is the leading region for hydro-electric power generation in India. The state is believed to have the potential to produce more than 21,000 megawatts (MW) of hydro electricity, of which just 6,000MW have been harnessed so far.

The Himachal Pradesh Energy Development Agency (known as Himurja) is the state agency responsible for the development of SHP projects of up to 5MW. It has already awarded around 300 projects to private firms, many of which have benefited from state government incentives and assistance with land acquisition. Investors are also promised expedited permit clearances and timely payments by the Himachal Pradesh State Electricity Board (HPSEB), which is required to purchase power from private SHP projects of up to 5MW at a fixed rate of Rs2.50 (US$0.05) per kilowatt (KW).

In SHP projects of less than 2MW in size, private investment is restricted to residents of Himachal Pradesh, who are also the preferred investors in larger SHP projects of up to 5MW.

Each private developer is permitted to build, own, operate and maintain a project for a period of 40 years, commencing 30 months after the date of execution of the implementation agreement. After the 40-year period, the project reverts automatically to the Himachal Pradesh government without charge and free from encumbrances.

The implementation agreement is the central agreement between the licence holder and the Himachal Pradesh government. Under the standard terms of this agreement, a licence holder may not transfer its licence, but can establish a separate entity provided that the licence holder owns at least 51% of the equity in the entity for a period of two years after the commencement of power generation. The remaining 49% of the equity may be held by a non-licence holder.

Small is beautiful

In the early 1990s India threw open its doors to foreign investment in the power generation and distribution sectors. Multinational energy groups such as Enron, AES, Mission Energy and China Light & Power rushed into the market attempting to establish ambitious large-scale power projects. Several of the mega-projects in this first wave of investment experienced difficulties. Many used coal or other fossil fuels which, aside from being environmental unfriendly, were prone to severe supply shortages in India.

Perhaps the most infamous example of a mega-project running into trouble was Enron’s Dabhol plant in the state of Maharashtra. Dabhol became enmeshed in political and economic controversies, with allegations of corruption and an excessive cost-per-unit of power being levied against the company. The situation was exacerbated by Enron’s bankruptcy in 2001.

In response to the problems that plagued many of the mega-projects, India’s central and state governments have started promoting smaller power projects that utilize clean energy as a viable and achievable alternative to fossil fuels.

Of the clean energy technologies available, hydro-electric power generation has arguably shown the greatest promise in India. According to statistics from the Central Electricity Authority, a statutory body that advises the central government on electricity policies, hydro-electric energy already accounts for roughly 25% of India’s total installed electricity capacity.

Financial incentives

India is one of relatively few countries to have a separate ministry for renewable energy. The Ministry of New and Renewable Energy (MNRE) was established in 1992 with the aim of facilitating the development and deployment new sources of clean power.

The MNRE, together with state agencies, provides several incentives for investors that establish small hydro-electric power projects. These include capital subsidies ranging from Rs15,000 per KW to Rs30 million per MW depending on the station capacity, and financial assistance of up to 100% on the cost of the initial survey and investigation, subject to a maximum of Rs150,000 per site.

In addition, the central and state governments provide incentives and favourable policies to encourage the establishment of SHP projects. These include exemption from excise and custom duties; capital subsidies for initial costs incurred by private players; and soft loans from the Indian Renewable Energy Development Agency, a government-owned company working under the MNRE. The loans are available for project financing, equipment financing, market development, and several other key areas of expenditure.

An added advantage of SHP projects is that they may qualify for carbon credits, or Certified Emission Reductions (CERs), if the relevant approvals are obtained from India’s National Clean Development Mechanism Authority. This is possible under the Clean Development Mechanism (CDM) of the Kyoto Protocol. The CDM allows projects that reduce greenhouse gas emissions in developing countries to earn carbon credits, which can be sold to companies in developed countries to help them meet their own emission reduction targets.

Regulatory clearances

The establishment of a private power project in Himachal Pradesh requires various regulatory clearances. The HPSEB has made it mandatory for investors to obtain the following statutory and non-statutory approvals prior to the commencement of a project:

  • A techno-economic clearance (TEC) from the HPSEB
  • Water availability approval from the Himachal Pradesh government and the Central Water Commission
  • Clearance from the HPSEB and the Himachal Pradesh government
  • Pollution clearance (air and water) from the State Pollution Control Board
  • Forest clearance from the State Forest Department
  • Environment clearance from the Ministry of Environment and Forests.

The TEC is a licence to generate power. Licence holders must submit three copies of a physical progress report to the HPSEB twice a year, along with details of the amount of expenditure they have incurred. These reports must be certified by statutory auditors.

Roll up, roll up

Generally the holders of TEC licences are small Indian companies or partnership firms. A major hurdle facing international investors, therefore, is identifying potential investee companies that have already been granted licences.

Once the licence holders have been identified, private equity investors often use a strategy known as “roll up play”. Using this approach, an investor would typically acquire several small companies in the same market, with the principal aim of obtaining economies of scale. Himachal Pradesh SHP projects are generally well suited to this style of investment and roll up play has proved a popular option for private equity investors.

The private equity fund would normally establish a holding company to own the various subsidiary companies. Alternatively it may combine or merge all of the companies into one larger entity. In structuring the entity, the investor must be mindful of the implementation agreement with the Himachal Pradesh government, which restricts the equity dilution of each licensee. The original licensee must retain a minimum stake of 51% in the entity holding the licence for a period of at least two years after the commercial date of production and generation. After the two-year period, the licensee is allowed sell its 51% stake to a domestic or foreign investor.

Fearing a lack of control, foreign investors are often averse to taking a minority stake during the initial two-year period. The deals may therefore be structured to include differential voting rights or affirmative voting rights, which afford the investor a greater degree of control. Differential voting rights allow one shareholder’s shares to have a disproportionately high number of votes, while affirmative voting rights provide that certain corporate actions may not be undertaken without a particular shareholder’s consent.

Offshore structures

Private equity investors using a roll up approach normally establish a holding company with subsidiaries that hold the TEC licences. In the case of the recent investment by the US private equity fund in two projects in Himachal Pradesh, the holding company was established in the US state of Delaware and a special purpose vehicle was set up in Mauritius.

Both jurisdictions present advantages and disadvantages. Delaware has minimal tax if no actual business is conducted in the state. It is has become the location of choice for many US-based private equity and venture capital funds and offers the added advantages of a familiar corporate law framework and a pro-business state government.

The key benefit of a Mauritius holding company is the India-Mauritius double taxation avoidance agreement, which provides benefits such as zero capital gains tax if the Mauritius entity sells its shares in an Indian investee company. Even if the eventual holding company is established in Delaware, the Cayman Islands, or one of many other preferred offshore jurisdictions, Mauritius entities are often interposed in order to obtain significant tax benefits.

It is also possible to establish an Indian entity as a holding company. However, the establishment of a foreign-owned Indian holding company may require the approval of the Foreign Investment Promotion Board.

Sustainable investment

In a report published last month, the International Monetary Fund forecast that India’s economy would grow at a rate of 6.4% in 2010. To facilitate and sustain such growth, the country’s power needs must be serviced urgently.

According to the minister of state for power, India currently has a shortfall of 15,000MW of electricity. This presents severe obstacles for the country’s development, particularly because primary sectors of the economy such as industry and agriculture depend heavily on reliable and sustainable supplies of power.

With the country’s demand for power seemingly assured in the short and medium term, roll up plays by private equity investors in Indian SHP projects look set to remain an attractive option.

Shantanu Surpure is the managing attorney of Sand Hill Counsel. The firm has offices in Mumbai and Silicon Valley and specializes in venture capital and private equity. This article was written with assistance from the firm’s associates Nischal Reddy and Nisha Mallik.