Presidential directive to end coal supply woes?

By Neeraj Menon and Niharika Puri, Trilegal
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In the past few years, a severe shortage of coal in India has led to a huge energy deficit, restricting the ability of power companies to generate to their full capacity. The gap between the demand and supply of coal widened to 161.5 million tonnes in 2011-12. This gap has impaired the interests of various stakeholders in power projects as they are unable to meet power supply commitments under the power purchase agreements (PPAs) with off-takers.

Neeraj Menon Counsel Trilegal
Neeraj Menon
Counsel
Trilegal

Due to the shortage and uncertainty in the supply of coal, the Ministry of Coal (MoC) directed India’s largest, government-controlled coal supplier – Coal India Limited (CIL) and its subsidiaries – to enter into fuel supply agreements (FSAs) by 31 March for projects commissioned after 31 March 2009 and those scheduled to be commissioned by 31 March 2015.

The direction applied to projects that had entered into long-term PPAs with distribution licensees. However, due to opposition by the independent directors of CIL, these directions were not adhered to. As a result, the president of India on 3 April issued a decree directing CIL to comply with the MoC’s directions.

Likely impact

The decree directs CIL to sign FSAs with all power producers that have entered into long-term PPAs with distribution licensees and have commissioned their projects between 31 March 2009 and 31 December 2011, undertaking a supply commitment of 80% of the contracted quantity of coal required by the power producers, in stark contrast to the 50% commitment before the decree.

If the supply is less than 80%, CIL is required to either pay a penalty or satisfy the deficit with coal imports. However, the decree allows the board of CIL to choose the penalty rates under the FSA and also proposes incentives for the supply by CIL of over 90% of the contracted quantity.

The directions in the decree pose mammoth challenges for CIL in terms of the capacity required to meet the demand. The aggregate demand under the FSAs is likely to exceed the current and near-future production capacities of CIL and its subsidiaries. In the likely event of a shortfall in the supply of domestic coal, CIL might have to import coal to meet its supply commitment under the proposed FSAs and avoid paying penalties.

Niharika Puri Associate Trilegal
Niharika Puri
Associate
Trilegal

It is uncertain whether the extra cost of imported coal will be transferred to the project developer by CIL, which in turn will be able to claim it as a tariff pass-through under its PPA with the distribution licensees. The import of coal will expose the project developer to the risk of price volatility, making it impossible for the developer to produce and deliver power on the basis of a competitively bid tariff.

Alternatively, since the penalty proposed by CIL for shortfall in meeting the assured supply is abysmally low (0.01% of the value of the deficit committed supply of coal), CIL may decide to forgo meeting its supply obligations using imported coal and consider the payment of penalties to be a more viable option.

Decree exceeds mandate?

The presidential decree not only undermines the rights and fiduciary duties of CIL’s directors, especially the independent directors, but also impacts the interests of the minority shareholders of the company. Inability to meet the aggregate supply commitment would result in CIL incurring high financial risks under the FSA, in terms of payment of penalty or importing expensive coal.

The lack of a judicial precedent on the legality of a presidential decree in relation to the management of a company has not helped the situation. CIL’s articles of association empower the president to issue a directive if the public interest is involved. However, if the increased cost of fuel incurred by CIL is ultimately to be borne by the end-user as a tariff pass-through, subject to this being permitted under the PPA, the element of public interest may be questioned.

If the PPA does not allow increased cost of fuel as a pass-through, the additional financial burden on power producers may affect the bankability of projects.

Finding a middle ground

Power producers are unhappy with the proposed penalty clause and also oppose the force majeure clause in the draft FSA, which has wide inclusions that are not standard. CIL and major power companies are deadlocked on signing the FSAs with these proposed clauses. Media reports say the power ministry is seeking the prime minister’s intervention to quash the new FSAs.

While various steps may be taken to help CIL meet demand through its current reserves and scheduled capacity addition in the short term, implementing global standards in mining processes may be the way forward to reduce costs and improve efficiencies.

Neeraj Menon is a counsel in the Delhi office of Trilegal, where Niharika Puri is an associate. Trilegal is a full-service law firm with offices in Delhi, Mumbai, Bangalore and Hyderabad.

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