Power purchase agreements- A relic that must be relegated to history

 

Power Purchase agreement (PPAs) are relic of the command economy and was initially formulated for greenfield capacity building. PPAs are long term contracts (i.e. 25 years) where power producers (Gencos) and DISCOMs agree to purchase power at a pre-determined tariff and pre-determined annual escalation over the next 25 years. There is a sizable fixed component that DISCOM needs to pay to Gencos irrespective of actual power purchased. This served as a revenue guarantee to Gencos in return to their capital investment. For DISCOMs it was expected to purchase power at a lower rate (variable cost) than otherwise market determined rate as the commitment is for long term purchase. Hence, DISCOM was a design to share the risk contractually between generating companies and distribution companies.

However, PPAs no longer serve the purposes of either the Gencos or the Discoms. DISCOMs in fact pay a much higher cost of supply compared to market prices. 

Below are the two reasons for non-viability of cost in PPAs:

1) Fixed cost to Gencos which accounts for 30% below (Niti Aayog Report-Electricity distribution report, August 2021, Page 39, table 2, Niti Aayog)⁷of cost of power purchase through PPAs relies heavily on DISCOM’s ability to forecast power demand leading to capex investment by Gencos. Since the Capex return is guaranteed through fixed cost paid by DISCOM and power demand now stagnating (as per figure below, DISCOMs has a burden to pay high fixed cost committed to higher capacity. As per estimates from Forum of regulators (CRISIL Report, Shorter PPAs need of the time, Oct 2021, Bridge to India)¹⁰ covering 12 states, the estimates of surplus fixed charges is INR 17,400 Cr.

2) The Variable cost under PPAs are at least 30% more expensive as per CERC discussion paper (Staff of CERC, Dec 2018, Page 12, Figure 9, www.cercindia.gov.in)¹¹. This is a result of demand in Silos by Discoms without any power exchange where information can be freely exchanged about un-requisitioned power.

Moreover, cost of capital for Gencos like NTPC is at least 27.7% higher than market average i.e. 6.5 Cr/MW market average v/s 9 cr/MW market average for NTPC (Economics Division, CERC, 2022, www.cercind.gov.in) . Given NTPC controls 24% (Press Information Bureau, Ministry of Power, Feb 23, pib.gov.in) of generation market share and majority of power is sold through PPAs, these factors significantly increases the fixed cost for DISCOMs.

2)   Even the variable cost of energy is high for Gencos committed to purchase through PPAs. The figure below is from a discussion paper by CERC (Staff of CERC, Dec 2018, Page 8, Figure 5, www.cercindia.gov.in) in 2018 depicting the problems of DISCOM ordering in SILOS to their PPA generators. One can observe that the Genco 3 which has a PPA with Discom A has un-requisitioned surplus from Genco 3 but Discom C is still buying at a higher variable cost from Genco 6,7 &8. There is no information sharing by DISCOMs nor is a liquid exchange for the power transactions.

 

 

 

Figure : Self Scheduling/Merit order in silos

Source: https://cercind.gov.in/2018/draft_reg/DP31.pdf

The same CERC discussion paper demonstrates (CERC Staff of CERC, Dec 2018, Page 12, Figure 9, www.cercindia.gov.in) that DISCOMS actually are paying a premium even on variable power through the PPA route. The did a study of 5 states (Andhra Pradesh, Karnataka, Telangana, Maharashtra, Chhattisgarh) and  based on their power purchases in July 2016. They found that if the power were purchased through pooled dispatch based on cheapest  un-requisitioned power rather than PPAs, the marginal variable cost would have come down by at least 30%.

 

 Figure: A comparison between actual dispatch and pooled dispatch

Source: https://cercind.gov.in/2018/draft_reg/DP31.pdf

It is pertinent that the current PPA regime through which ~87% (Staff of CERC, Dec 2018, Page 5, Figure 2, www.cercindia.gov.in) of power is purchased today  should be replaced with open exchange-based market which currently accounting for only 4% (Staff of CERC, Dec 2018, Page 5, Figure 2, www.cercindia.gov.in)

The biggest hindrance to open exchange-based market is from financers and regulators to assume market risk (CRISIL Report, Shorter PPAs need of the time, Oct 2021, Bridge to India) . This is rather unfounded because the current system is littered with defaults, litigations, PPA renegotiations and stranded capacity. Moreover, market can think of derivative instruments to hedge too much daily fluctuations instead of a market distorting long term purchase agreements.

CERC already proposed implementation of Market Based Economic Despatch (CRISIL Report, MBED the biggest potential reform of India’s archaic power, July 2021, Bridge to India)¹⁴ where DISCOMs are expected to submit bids to buy and sell power to power exchange with disclosure of the variable charges in existing PPAs rather than placing it directly with contracted PPAs. In this mechanism, lower of the agreed variable pay and market rate. The fixed cost will be paid directly to the contracted PPA. The plan is to have a pilot with NTPC only from Gencos but to include all DISCOMs. This alone is expected to reduce the cost of supply by 7%.

 A Simulation on DISCOM viability without PPAs

The revenue gap in DISCOM is INR 104,091cr which is 19% of the total power purchase cost. As discussed in the alternative, if a market based pooled purchase is devised instead of PPAs, a study by CEC demonstrated that the marginal variable cost is expected to come down by 40%. As the variable cost represents 60% of cost of supply, a market-based rate alone has a potential to reduce cost of supply by at least 30% effectively making the expense revenue gap to 0. Moreover, there is a potential to reduce fixed cost significantly by moving into exchange based market as the current excess fixed cost to be paid by DISCOMs stand at 17,400 cr which is further expected to go away if PPAs are terminated. This 17,400 Cr can instead be paid as termination charges for PPAs to Gencos so that there are systemic losses introduced into the Gencos. Moreover, this would also force the Discoms to settle real time to Gencos as the power will be settled real time in market. This is a market enforced behaviour and govt also has to timely provision for regulatory and subisidy settlement as without real time settlement, provisioning power in open market exchange is going to be impossible irrespective of the ownership structure of DISCOM. It will over time reduce the interest burden of DISCOMs as well. Gencos also needs to efficiently allocate capital as there will no longer be guaranteed return on capital. Particularly companies like NTPC will have to eliminate the 27.7% premium cost of capital.

  A simulation below shows that if the gains from open market (30% in variable cost as per CERC study) and surplus fixed cost reduction can alone solve the DISCOM cash flow (ACS ARR gap) shortfall to Zero without changing anything in the tariff structure.

Simulation in case pooled power is purchased instead of PPAs

The above table shows that just by optimizing variable cost as per the CERC discussion paper and saving on surplus Capex cost by terminating PPAs, we can narrow the ACS ARR gap to zero. One can argue that the surplus fixed cost reduction is a stock variable and must not be considered for OPEX working. However, if we also factor the savings through lower cost of capital for Gencos like NTPC which is passed to DISCOMs through PPAs, the ACS ARR gap will be surplus.

 

This is a low in cost alternative to contain DISCOM Losses and achieve operational efficiency however this alternative is long drawn as PPAs cannot be terminated immediately and power market will not become very liquid in the short span. However, one must concur that this is a low hanging fruit to contain DISCOM losses without touching the tariff structure.

References: 

1)   CRISIL Report, Oct 2021, Shorter PPAs need of the time, Bridge to India- A CRISIL Subsidiary (https://bridgetoindia.com/shorter-ppas-need-of-the-times/)

2)     Staff of CERC, Dec 2018, Discussion Paper on Market Based Economic Dispatch of Electricity: Re-designing of Day-ahead Market (DAM) in India, (https://cercind.gov.in/2018/draft_reg/DP31.pdf)

3)   Economics Division, CERC, 2022, Report on Short-Term Power Market in India 2022-23, www.cercind.gov.in (https://cercind.gov.in/2023/market_monitoring/Annual%20Report%202022-23.pdf)

4)    Press Information Bureau, Ministry of Power, Feb 23, NTPC ranked as the top independent power producer and energy trader globally by S&P Platts, pib.gov.in (https://pib.gov.in/PressReleasePage.aspx?PRID=1901700)  

5)    CRISIL Report, July 2021, MBED the biggest potential reform of India’s archaic power, Bridge to India- A CRISIL Subsidiary (https://bridgetoindia.com/mbed-the-biggest-potential-reform-of-indias-archaic-power-sector/ )