ICRA Rating Feature

Fuel Supply Risks loom over New Coal-Based Thermal Power Projects

Contacts:
Anjan Ghosh aghosh@icraindia.com +91-22-3047 0006

Overview
The demand for coal in India has been increasing at a rapid pace, driven largely by the thermal power sector that accounts for around 70% of the total domestic coal consumption. The spurt in demand has led to a significant rise in import levels, given the failure of domestic coal production to keep pace with the increasing demand because of structural bottlenecks that prevent quick commissioning of mining projects. The demand-supply gap in the domestic coal industry is likely to widen significantly over the medium to long term, largely because of the significant size of the coal-based power projects that are expected to be commissioned over this period. Many of these projects were conceived on the premise that domestic coal would be available to them in the required volumes. While such projects have been able to secure Letters of Assurance (LoAs) from the Coal India group, such contracts actually guarantee coal availability of 50% of their annual requirements from domestic mines. The shortage therefore is likely to be met from imported coal, which is typically costlier and also witnesses large price swings. Additionally, the availability of imported coal too could be a challenge going forward, if Indian companies were to resort to large scale imports. Higher fuel prices for many new coal-based power projects could adversely impact project returns and undermine the debt service capabilities of the project promoters, especially those that do not have a pass-through of fuel costs in their Power Purchase Agreements. Given this likely scenario, many Indian companies have been scouting around for captive coal assets in foreign countries. While this would address the fuel supply risks that they may face, such companies would still have to contend with countryspecific risks. Further, the financial risk profiles of these companies would also be impacted by the level of investment required and the funding structure for the same. While some risks associated with a tight demand-supply situation in the coal sector would apply to several industries, this note specifically examines the likely impact of the same on the new coalbased thermal power projects that are in the process of being commissioned.

Jayanta Roy jayanta@icraindia.com +91-33-2280 0008

February 2011

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Imports rise on the back of booming domestic demand for coal Domestic coal demand reported a compounded annual growth rate (CAGR) of over 8% during the period 2005-06 (FY2006) to FY2010 to reach almost 600 million tonnes last year (Chart 1). The demand from the power sector, which accounts for over 70% of the countrys overall coal demand (Chart 2), has been a major driving force behind the demand growth. Other sectors that have also played a role in the increase in demand include steel, cement, and brick kilns. While domestic coal production also reported growth during FY2006 to FY2010, the pace was slower at under 7% (CAGR) relative to the over 8% (CAGR) demand growth during the same period. The major problems that have constrained production growth include, among others, delays in obtaining various regulatory approvals for coal mining projects, and disputes over land acquisition as well as rehabilitation and resettlement of the project-affected people. Political unrest in remote locations that have large coal deposits has also added to the challenges in commissioning coal projects in recent times. Consequently, as Chart 1 shows, the gap between domestic demand and supply has widened over the years, necessitating larger imports. Chart 1
Coal Demand-Supply Position
600

Chart 2
Share of Coal Consumption by Industry in 2008-09
Cement 3% Steel 11% Others 15%

500
400 300 200 100 0

Million MT

Power 71%

2005-06

2006-07

2007-08
Coal Demand

2008-09

2009-10

Coal Production

Total Import

Source: Outcome Budget of 2010-11, Ministry of Coal (MoC), and ICRA research

Demand-supply gap likely to increase at a faster pace, going forward Considering the large size of the coal-based thermal power projects that are in the process of being commissioned in India, ICRA believes that the power sector would continue to remain the prime driver of coal demand in the medium to long term. As Chart 3 shows, from around 71 Giga Watt (GW) at the end of the Tenth Plan period in FY2007, the installed capacity of coal-based thermal power plants (TPPs) increased to 90 GW at the end of November 2010. While capacity addition in the Eleventh Plan period was initially estimated at 50.5 GW (excluding lignite-based TPPs), the Central Electricity Authority (CEA) has revised the estimate downwards to around 41.9 GW now, which points to an installed capacity of around 113 GW at the end of FY2012. However, the revised target still represents growth of around 34% over the installed capacity in FY2010. Additionally, according to estimates, coal-based TPPs with a total installed capacity of another 50 GW or so are currently at various stages of commissioning and are likely to be completed during the Twelfth Plan period. Assuming the same level of commissioning efficiency as is expected for the current Plan period, the total installed capacity of coal based TPPs would increase by a sharp 70% or so over the current levels of around 90 GW in the next five to seven years, in ICRAs estimates.

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Chart 3
Trend in Coal-Based Thermal Power Capacity
100

90

80

GW
70

60

50 2006-07 2007-08 2008-09 2009-10 Nov-10

Source: Ministry of Power (MoP) and CEA The average quality of Indian thermal coal is inferior to that available in other countries like Australia, Indonesia and South Africa. Assuming a calorific value of 3,500 kilo calorie (Kcal) per tonne of domestic coal, a plant load factor of 85% and a station heat rate of 2,500 Kcal/unit of energy, the incremental capacity envisaged is likely to generate an additional coal demand of over 335 million tonnes annually. This, along with the anticipated growth in the capacities of various other industries including steel, aluminium and cement that directly or indirectly (through captive power plants) use thermal coal, is likely to cause a very sharp growth in domestic coal demand in India over the next five to seven years, although a number of TPPs are likely to be based on imported coal. As against the anticipated surge in demand, the bottlenecks on the supply side, given the structural nature of the issues, are likely to persist in the foreseeable future, thereby constraining growth in domestic coal production. ICRA therefore expects coal production to continue growing at the historical trend rate of around 7% per annum, going forward. At this rate, the domestic demand-supply gap is likely to more than treble over the next five to seven years from the current levels of around 67 million tonnes (using imports as a proxy for the gap). Interestingly, while the MoC, quoting from the Mid-Term Appraisal report for the Eleventh Plan period, has estimated an import requirement of 83 million tonnes in FY2012 to bridge the domestic demand-supply gap, Coal India Limited (CIL), which accounts for over 80% of the domestic coal production, has stated (in its Red Herring Prospectus) that it would face a shortfall of an estimated 110 million tonnes and 235 million tonnes in FY2011 and FY2012 respectively, if all TPPs with LoAs from CIL are commissioned in time. Although a number of coal blocks have been allotted since the 1990s to private players in the power, steel and cement industries for meeting their captive requirements, the progress made in bringing these blocks to production has been quite unsatisfactory till date. According to the Annual Report, FY2010, of the MoC, of the 208 coal blocks allotted to various companies including ultra mega power projects till FY2010, only 25 mines had been commissioned till the fiscal year-end and were producing coal at the nominal levels of 7-8% of the countrys total production. The problems being faced by the corporate sector (except coal mining companies like CIL), besides the ones discussed earlier, include lack of experienced manpower with a track record in commissioning large coal projects.

Many new TPPs likely to face high fuel supply related risks Many ongoing thermal power projects have been initiated on the assumption that the required volumes of coal could be available from domestic coal companies, primarily the CIL group. Since April 2009, CIL has started allocating coal under a new frameworkNew Coal Distribution Policy (NCDP)replacing the earlier system of coal allocation. Under the revised system, CIL has been issuing LoAs to new customers

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including TPPs whose projects have been/would be commissioned after April 2009. The LoA gives an assurance to the TPP on future supply of coal, subject to the fulfilment of certain conditions and the achievement of certain project milestones by the TPP as specified in the LoA. Once the conditions and project milestones are met, the LoA holders become eligible to enter into fuel supply agreements (FSA) with CIL. In addition to the FSAs applicable to such customers, CIL also enters into memoranda of understanding (MoUs) with them, and these MoUs form an integral part of the FSAs. A careful study of the NCDP related documents reveals that CIL would commit up to 50% of a TPPs Annual Coal Quantity (ACQ) from domestic sources. Any incremental supply beyond this limit may have to be imported at the TPPs cost, the arrangement for which would however be made by CIL on behalf of the TPP concerned. The FSA also stipulates that for calculating compensation for short delivery, only indigenous coal allocated by CIL would be considered as the contracted ACQ. According to the NCDP, customers are also entitled not to opt for the option of CIL supplying imported coal and accept only indigenous coal. However, in that case, only 50% of the original ACQ would be considered as the effective ACQ. The terms and conditions of the NCDP discussed clearly transfer the risk of non-availability of domestic coal to TPPs despite their holding valid LoAs and executing their projects efficiently. ICRA therefore expects many coal-based TPPs to have no other option but to import thermal coal, either directly or through CIL. Either way, they would be exposed to considerable volatility in the prices of imported coal, unless they are (or CIL is) able to secure stable supplies under more predictable long-term pricing 1 arrangements with the suppliers . Even then, volatility in shipping rates and exchange rates would be issues that the TPP would have to contend with. While incremental port capacities in India, especially for handling imported coal, are likely to allow large scale imports over the medium to long term, evacuation of the imported coal from the port to the power station would remain a key challenge, given the inadequacy of the current evacuation infrastructure and the slow progress being made on this front. Chart 4 depicts the trends in international thermal coal trade and the share of Indian thermal coal imports during the last five years. As seen, notwithstanding an increasing trend, India accounted for a nominal 6% of the total international trade in thermal coal in FY2010. The estimated demand-supply gap in the domestic market, if met through imports, is likely to lead to a sharp increase in Indias share over the medium to long term, assuming that the internationally traded volumes would be able to support Indias enhanced requirements. Chart 4
Indian Imports vs. International Thermal Coal Trade
International Trade in Million MT
1,200 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 2005-06 2006-07 2007-08 2008-09 2009-10 Internaional Trade in Thermal Coal 2014-15 f India's Share

1,000
800 600 400 200 -

Source: ICRA research

According to news reports, CIL has been attempting to enter into coal procurement arrangements with international coal companies under long-term pricing arrangements. ICRA Rating Services Page 4 of 6

Share of Indian Imports

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Currently, domestic coal is significantly cheaper than imported coal even on a calorific basis, and a sharp rise in Indian imports could exert a significant upward pressure on international prices, going forward. Consequently power projects, which will have to partly depend on imported coal, may see their cost of production increasing beyond anticipated levels. This in turn may adversely impact their overall returns and seriously affect their debt service ability. Even if a TPP were to restrict the plant load factor to the level permitted by domestic coal availability, the project economics would, in all likelihood, suffer. Thus, a number of Indian entities have been scouting around the globe to secure overseas captive coal assets. While the success of such ventures can significantly mitigate fuel supply risks, the business risk profiles of such entities would be impacted by country-specific risks, besides the capital requirement and the way the purchase of such assets are funded.

Conclusion Indias ambitious programme of adding to its power generating capacity relies heavily on coal as a source of fuel. While several independent power producers (IPPs) have been able to achieve financial closure on the basis of the LoAs signed with domestic coal companies, the ability of the fuel supplier to actually supply the contracted quantities remains to be seen; it is not unlikely that domestic sources would be unable to meet more than 50% of the assured quantities in some cases. Shortfalls in the supply of domestic coal could expose the IPPs to fuel price and supply related risks, given the challenges involved in securing coal at competitive rates from alternative sources like imports. The business risk profiles of entities resorting to coal imports could therefore be affected adversely, the impact being more severe for those that do not have a pass-through of fuel costs in their Power Purchase Agreements.

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