India's power sector is looking forward to the second phase of reforms under the government's Ujwal Discom Assurance Yojana (Uday). S&P Global Ratings believes that unless systemic issues stemming from ailing state-owned power distribution companies (Discoms) are first resolved, the success of Uday 2.0 may be a tall order. Uday 2.0 will follow up on the government's initiatives under Uday 1.0 launched in 2015.

India's long ailing Discoms are far from recovery. Their weak financial health and payment delays will continue to weigh on the credit profile of the power sector. However, power purchase agreements (PPAs) remain a key credit strength for the power generation and transmission companies, providing strong revenue visibility. The PPAs are generally long-term fixed-price, and follow merit order or "must-run" status on renewables (that guarantees dispatch on generation, barring grid stability issues). High cash flow visibility from PPAs helps to offset the drag on power companies' working capital due to payment delays from Discoms--which has been the industry norm.

In the past few weeks, Discoms under the new state government of Andhra Pradesh have attempted to renegotiate executed contracts. They are questioning the must-run status of renewables and resorting to curtailment in order to avoid paying under the PPAs. This puts the fundamental long-standing credit protections for the power sector at risk.

We believe revisiting executed contracts can violate the sanctity of the contractual framework in India. Such renegotiation will also undermine investor confidence at a time when the government is seeking to attract increasing private sector investments across sectors such as renewables, airports, and roads. Although the issue is still under judicial consideration, we expect contracts to be ultimately upheld (based on precedence). However, until the issue is fully resolved, power companies will face pressure on working capital due to nonpayment of dues and uncertainty on their future cash flows.

In our view, it is imperative to honor the executed contracts before embarking on new ambitious plans targeting structural reforms. In the past, PPA contracts have largely remained insulated from political changes (unlike what is now happening in Andhra Pradesh). Exposure to political risk leading to contract renegotiation can entirely defeat the purpose of fixed-price long-term contracts if states can reopen contracts at will. The central government's calls for upholding contracts while welcome, have largely gone unheeded.

Risks From Weak Discoms Remain

Weak health of counterparties--Discoms--remains one of the key rating constraints in India for power generation and transmission companies such as NTPC Ltd. and renewable players such as ReNew Power Ltd. and Greenko Energy Holdings (see table 1).

Table 1

Exposure to weak state electric utilities can cap the rating under our project finance methodology. For instance, higher covenanted exposure to stronger counterparties, such as NTPC and Solar Energy Corp. of India (SECI), is a key strength of Parampujya Solar Energy Pvt. Ltd. Restricted Group (PSEPL RG), compared to some other renewable companies we rate. We have a 'BB+' preliminary rating on PSEPL RG's foreign currency project bond--India's first. However, we will lower the rating if the counterparty credit profile weakens since material cash flows are also dependent on timely collection from relatively weaker Discoms from states such as Karnataka.

We view the government's initiative to tender projects under National Solar Mission through NTPC and SECI as generally positive for the renewable players. Timely receivables payment from NTPC and SECI is a key attraction (also enabling record low tariff rates) in an industry where Discoms often delay payments. Carefully managing the exposure of NTPC and SECI to any payment delays from Discoms is crucial so as not to impair their otherwise strong credit profiles.

Payment Delays Stretch Working Capital

Payment delays from Discoms are common in India, and it is unclear if this will change. Receivables days of less than 90 are considered efficient in the industry, although it is not unusual to see more than 180 days receivables. While the contractual mechanism allows for collection of penal interest, often the power companies waive penal interest in order to incentivize the repayment of overdue receivables.

The challenge in India is that Discoms keep changing their payment behavior. Therefore, the power companies cannot fully mitigate these risk by avoiding exposure to certain states. Large government-owned entities such as NTPC and Power Grid Corp. of India Ltd. have generally demonstrated a stronger collection track record than private companies. This is partly due to their size, government influence, and tripartite agreement with the central bank and the states. However, even these companies are experiencing delays in payments from states such as Andhra Pradesh.

The state of Maharashtra was earlier considered favorable by many players. Now the state has started delaying payments to some private renewable companies (particularly wind) over the past two to three years, resulting in delays of nine to 12 months for some companies. Overdue payments were then arranged to be paid in instalments.

Curtailment risk in Tamil Nadu and payment delays from Andhra Pradesh show that Discoms' track record of payment can also change based on political and financial pressures.

We believe the payment delays are unlikely to improve in the short term as the issue remains under judicial consideration. We now expect Indian rupees (INR) 10 billion-INR15 billion negative working capital movement for Renew Power Ltd. annually due to ongoing delays in payments from Discoms in Andhra Pradesh. Renew Power Ltd.'s 20% revenue contribution from Andhra Pradesh will expose it to the lengthening payment delays from the state's Discoms (see table 2). Greenko also obtains nearly 40% of its revenues from Andhra Pradesh, and this can strain its working capital.

Table 2

Greenko was also evaluating a large energy storage project in Andhra Pradesh tendered by the previous government; the project appears uncertain under the new government. The state Discom attempted to reduce the tariff rate on Greenko's tariff to INR2.44 per kilowatt hour (kWh) retrospectively from Oct. 27, 2017, from INR3.74 per kWh, on one of the contracts. An appellate court has stayed such revisions. However, timely full payment on such contracts will remain uncertain.

Uday 1.0 Is Pragmatic But Not A Panacea

In our view, Uday 1.0 was the need of the hour--then. Tight liquidity and high borrowing costs at Discoms had been exacerbating payment delays for the entire power sector and further weakening the health of Discoms. Over INR2.3 trillion of bonds (more than US$33 billion or 86% of the government target) have been issued since 2015, relieving some of the liquidity pressures and reducing borrowing costs. However, limited progress in cutting down the high aggregate technical and commercial losses (AT&C losses), elements of subsidized tariff, and weak financial health of Discoms will offset some of these upfront gains. Improving the financial health of state electric utilities is still an ongoing job.

Power ministry officials have indicated plans to announce Uday 2.0 over the coming weeks. Uday 2.0 will reportedly combine multiple schemes and incentivize Discoms for efficiency. Reliable power supply and reducing AT&C losses--two long-standing pain points--are likely to be the main focus.

We believe the key measure of success for Uday 2.0 will be the level to which it will structurally repair the financial health of Discoms and reduce AT&C losses.

Discom Privatization Could Be A Solution

We believe privatizing Discoms can be a viable solution to power sector woes provided the government (including state governments) sticks to meeting all contractual terms and conditions.

Privatization can bring an urgency to improving AT&C losses--one of the biggest credit hurdle for Discoms. Tata Power Co. Ltd., which took over distribution in Delhi in 2002 after privatization, reduced AT&C losses to 7.92% as of March 31, 2019, from 53% at end-2002. System efficiencies translate into cheaper and more efficient power supply. However, free power and subsidies (more new subsidies are proposed in August 2019) resulting in deferred revenue compensation in Delhi create uncertainties on cash flows and collections. We believe such negative state interventions can dampen private investor interest.

L/Cs Can't Mitigate Counterparty Risk, Unless Strictly Enforced

Letters of credit (L/Cs) are unlikely to fully mitigate counterparty risks. In our view, this mechanism can provide additional protection but not replace the inherent risk of delayed payments due to the weak financial standing of Discoms.

Some contracts in the past also stipulated provision of L/Cs for monthly dues, which have not been provided in many cases. Maintenance of 10 days of rolling L/Cs is being considered by the power ministry as one of the possible solutions, which in itself does not provide added protection. Even where L/Cs have been maintained in the past, power companies have been very reluctant to invoke the L/Cs to avoid damaging the relationship with state counterparties, which provide existing and new business. Add to it the political pressures, and invoking an L/C can be tricky. The ability of some Discoms to obtain and provide such L/Cs also remains questionable due to their weak financial health.

The power industry is keen to have a bill discounting mechanism under which the Reserve Bank of India (RBI, the central bank) discounts the bills for dues from states. On the due date, in case of non-receipt of payments from Discoms, the industry expectation is for the RBI to directly debit the state budget account to deduct recoverable dues. This could provide a strong mechanism to alleviate receivables collection issues. Adoption and implementation of such a scheme remains uncertain, in our view, given significant fiscal and political considerations.

A Strong Foundation Is Essential

Over the decades, the Indian power industry has echoed a popular refrain: Payments are delayed, but there are no defaults and PPA contracts are always honored. But contractual breaches can erode investor and funding confidence at a time when banks are only lending selectively. Also, cash flow visibility will be lost and project finance, which relies solely on contractual and documentary framework, could be choked. Investors and corporates with deep pockets may be able to tide it out but not without scars. These issues are not new or unknown, but have now assumed an increased urgency due to the public display of contractual breaches. That's why India needs Uday 0.0 so that Uday 2.0 isn't built on shaky ground.

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