Prime minister out to aid coal-hungry power sector

By Avirup Nag and Amrinder Singh, Trilegal
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While India’s coal reserves are among the largest in the world, the Indian power sector, which is one of the largest consumers of domestic coal, has been hit hard by the unavailability of coal. The problems of the coal sector, which have in turn affected the power sector, are well documented.

The current contractual framework for fuel supply protects coal suppliers if they supply up to 50% of the normative requirement under the fuel supply agreement (FSA). Power producers need an alternate source for the remainder and, to bridge the gap, often have to import coal, leading to significant increases in fuel cost.

Out of sync

In most international power purchase agreements, the coal supplier bears the risk of failing to supply the contracted quantity of coal, and is liable to pay the power producer liquidated damages, on a supply-or-pay basis, for such failure. Also, fluctuations in fuel price are usually a straight pass-through to be borne by the ultimate consumers. Unfortunately, the current regulatory and contractual position in India does not reflect this in either aspect.

Avirup Nag Senior associate Trilegal
Avirup Nag
Senior associate
Trilegal

In view of this, a recent report by Moody’s said the current structure of the Indian power sector is unsustainable, and a slowdown in lending to the sector by both domestic and foreign lenders reflects their wariness about its structural weakness. Recognizing the need to make the power sector more investment-friendly, partly by ensuring fuel supply certainty, the Prime Minister’s Office (PMO) has intervened to begin to rectify the situation.

The PMO on 15 February directed Coal India Limited (CIL) to sign long-term FSAs for all thermal power projects to be commissioned by the end of March 2015, provided that such power projects enter into long-term power purchase agreements with distribution utilities. For power plants that were commissioned by 31 December 2011, CIL is required to execute long-term FSAs by the end of this month.

20-year term

The PMO’s directives provide that the new FSAs are to be for a 20-year term, as opposed to the five-year FSAs currently being offered by CIL, and should be for the full quantity of coal specified in the letters of assurance issued to the power producers. If CIL supplies less than 80% of the contracted quantity, it will have to arrange for additional coal either through imports or arrangements with public-sector units which have been allotted coal blocks.

Under the new FSAs, CIL will be eligible for an incentive if it supplies above 90% of the guaranteed amount.

In another positive development, the government is also considering a waiver of the 5% customs duty on coal imports to mitigate the impact of the increase in international fuel prices on power producers without hiking the electricity tariffs. It is understood that this tax relief was to be part of the government’s budget proposal.

Easier said than done?

The PMO’s moves may boost investor confidence and provide comfort to lenders. However, the major challenge for the government will be implementation.

Amrinder Singh Associate Trilegal
Amrinder Singh
Associate
Trilegal

The announcement of the new contractual arrangement comes at a time when coal production by CIL is expected to fall short by 27 million-30 million tonnes, partly because of stalled projects, flooding in coal-producing areas and strikes. Further, the Ministry of Environment and Forests has blocked several environmental clearances, making some coal reserves unavailable for mining at present. Also, CIL’s attempts to acquire mining assets abroad to boost its production have been largely unsuccessful so far.

Therefore, a big question mark hangs over CIL’s ability to honour its commitments under the FSAs. It may not be viable for CIL to import coal as the cost of fuel is not passed through to the ultimate consumers under the power purchase agreements. Further, the Ministry of Coal tried previously to increase the amount of coal available by directing captive mining companies to supply surplus coal to the nearest CIL subsidiary at a low price. However, this was opposed by the Ministry of Law and Justice as it was contrary to a stand taken by the government earlier.

Conclusion

While the intervention of the PMO is a step in the right direction, the government needs to address the core structural issues affecting the coal sector and to bridge the supply-demand gap in the case of domestic coal. The government also needs to balance efficient use of coal reserves and environmental concerns, improve mining efficiency and address coal transportation issues. How the government deals with the root causes of the supply-demand mismatch will determine whether these steps will ultimately help rejuvenate the power sector.

Avirup Nag is a senior associate in the Delhi office of Trilegal, where Amrinder Singh is an associate. Trilegal is a full-service law firm with offices in Delhi, Mumbai, Bangalore and Hyderabad.

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