Solar capacity has been growing at a jaw dropping pace in India.
What is especially remarkable is the range of stakeholders that play a part in this story. The central government, national level policymakers, national & multilateral agencies, state level governments, central off-takers, state level Discoms, private developers taking equity risk, EPC folks, hardware suppliers, sources of debt finance, corporate customers, individual customers - the list is literally endless. I am a big believer in solar, and sure we will have some bumps along the road, but I am also certain that fairly soon we will all look back to the current times and say “that’s when everything began to change”.
Under the circumstances it is natural that a business with such a demonstrated potential to radically alter our way of life will attract strong opinions and views from its diverse range of stakeholders. As a result it can also be expected for certain misconceptions, or “myths” to creep in and firmly establish themselves in the discourse. In this piece I highlight the top 5 myths as I see them and provide my contrarian views on each.
Myth #1: “Payments are secure as the off-taker is an A+ rated state Discom”
This kind of statement is often erroneously made in support of the credit worthiness of various state Discoms. For the past five years the Ministry of Power has been releasing its “State Distribution Utilities Integrated Rating”, an annual review conducted jointly by ICRA and CARE. This is clearly a big step towards filling a significant gap in our understanding of state level Discoms, but despite its title (which includes the word “Rating”), the 41 Discoms have not been assigned credit ratings but in fact rankings on a “grading” scale of A+, A, B+, B, C+, & C. It may seem like a fine distinction but it’s actually an important one. The principal objective of any credit rating exercise is to assess the ability of an entity to meet its financial obligations via an assessment of probability of default. On the other hand the purpose of the abovementioned annual grading exercise is to measure the operational & financial health of the individual Discoms, and that too only relative to the narrow 41 member peer group. No doubt an A+ graded Discom will be in relatively far better shape than one graded C, but such a grading does not throw adequate light on its credit worthiness per se. Evaluating the ability to meet financial obligations is a far more onerous test than the measurement of operational & financial health.
Myth #2: “Solar’s must run status offers protection from curtailment”
Solar PPA’s in India are not “Take or Pay” but more in the nature of “Pay for what you Take”. So how come thousands of MW of solar capacity has been put on the ground without a watertight obligation on the state Discoms part to pay for deemed generation? The answer lies in solar’s (and wind’s) “must run” status which is part of India’s Electricity Grid Code notified by the Central Electricity Regulatory Commission and which has further been adopted by various State Electricity Regulatory Commissions. This means that in theory, renewable energy should not be made subject to merit order dispatch for commercial (read high tariff) reasons and therefore Discoms & SLDC’s are obliged to let these plants run without interruption. The reality is quite different and certain Discoms are in fact repeat offenders when it comes to forcing solar power generators to back down in the name of “grid security” – a loophole in the grid code which allows them to issue such instructions.
Whether the back down or curtailment results from genuine reasons arising due to infrastructure incapable of handling solar’s intermittent nature, or due to commercial considerations in the garb of grid security, the result to the generator is the same – a permanent loss of revenue which by the way is far more value destructive then any delay in payments.
The fact remains that some Discoms will always be riskier contractual counterparties than others so taking shelter under must run status cannot replace a 360 degree assessment of the Discom at the time of tariff bidding- which assessment in my opinion will continue to be crucial even when (if?) compensation for deemed generation becomes a reality.
It is for the above reason that I don’t treat Madhya Pradesh’s recent move to withdraw solar’s must run status with great alarm. It is for a similar reason that I also don’t think developers are necessarily immune from state specific risks even with a NVVN (NTPC’s trading sub which executes solar PPA’s) off-take as we have seen in the case with Andhra Pradesh reportedly demurring from its share of purchase obligation from power generated in Kadapah solar park located within the state (as an aside it will be really interesting to track how this particular situation pans out!).
Myth #3: “Utility scale solar is ripe for consolidation”
M&A transactions in the utility scale solar space have already commenced and will undoubtedly pick up pace going forward. However, these transactions have nothing to do with consolidation. Consolidation takes place for reasons such as top line protection, cost savings, other scale benefits or to simply thwart a looming existential crisis. The reasons driving solar transactions are very different.
Let’s take the case of project SPV’s first. Whether you are a 5MW or 500MW solar project SPV with the same off-taker and tariff, there is no meaningful difference in survivability or other operational and financial metrics. Each of these projects will fare similarly and combining the two does not change the situation for either of them. Sure, there is an O&M cost saving that comes with scale, but it’s not a make or break type of figure. In reality project SPV level transactions take place because of “Push” & “Pull” factors. Developers seek to divest portfolio’s because they need to recycle capital and put it to play in a market where a massive amount of capacity is yet to be developed (the “Push”). On the other hand financial institutions (and not developers) with financial engineering and distribution capability seek out execution risk mitigated project SPV’s (the “Pull”) because they have access to an investor base who likes the underlying cash flow. This change of hands in ownership is a natural step in the life cycle of the solar project SPV and should not be confused with consolidation.
This brings us to the question of solar project developers. Development is the art of cobbling together the various pieces (bidding, EPC, financing etc) that make a project and in that sense it’s a very people centric business. However, this also means there is very little proprietary and of value at a developer apart from its people. Accordingly, with large solar developers pulling ahead of the pack there’s not much benefit for them to bring smaller development platforms under their wing on the one hand, and a questionable case for smaller development platforms to combine to fight the big boys on the other. So in the case of solar project developers, rather than M&A transactions at a corporate level, talent will simply move across platforms in a personal capacity and marginal development platforms will just vanish from the scene.
Myth #4: “Falling tariffs make projects with high tariffs more attractive to buyers”
The complete opposite is more likely to be true, ie, falling tariffs make high tariff projects actually look less attractive and not particularly more valuable to a buyer.
Let’s address the value bit first. All other things being broadly the same (off-taker, technology, irradiance, cost of debt etc), the return for an owner of a solar plant is a broadly a function of the tariff at which he sells the electricity vs capital cost. Falling tariffs would result in reduced IRR’s for new developers if the fall in tariffs outpaced the fall in capital cost - which is indeed what has happened in India. Furthermore, from a buyers perspective projects with different tariffs (all other things remaining the same) should be priced at an IRR bench marked against returns from the latest discovered tariff just like you would for a bond. What this means is that a buyer going out into the solar market place should logically find that whatever project he looks at, and whatever the underlying tariff may be, the various asking prices should result in IRR’s to him in a very narrow range. So no significant difference in “value” to the buyer.
However all other things are not really the same and the most important distinction is the tariff level itself. Projects with a tariff significantly higher than the Average Power Purchase Cost (APPC) of the Discom they sell to will increasingly be susceptible to curtailment particularly in the case of the less disciplined Dicoms. We are already seeing some of the creative ways in which Discoms are sidestepping off-take and this risk is only likely to increase.
In a nutshell, if secondary marketplace valuation expectations behave in a way that results in levelized acquirer returns irrespective of the underlying tariff, it is preferable to acquire a lower tariff project thereby securing peace of mind on the curtailment front – which is the biggest risk for any solar project. Or alternatively high tariff project valuation expectations need to moderate to allow for an implied return commensurate with higher risk of curtailment.
Myth #5: “Foreign bidders with low cost of capital are driving down tariffs”
As I’ve argued in many instances, if a foreign company’s lower cost of capital was a sound enough reason to undercut its return expectations for third party assets and currencies irrespective of the target asset’s business and underlying inflationary risk, Japan would have acquired the whole world by now. Looking at it from the opposite direction, it’s a bit like saying that a company with say an estimated 20% cost of capital should decline an opportunity to invest in NTPC bonds priced at a 15% yield just because 15% is way less than 20%. In reality NTPC bonds trade at a yield of about half of 15% so the investment actually represents a riskless 100% profit.
Discounting cash flows for a target asset based on acquirer cost of capital rather than the target assets independently calculated cost of capital (based on its own risk profile) will inevitably result in a portfolio of value destroying assets, missed investment opportunities or both. To the extent bidders (both local & foreign) have dramatically driven down tariffs it is not because cost of capital or return expectations have suddenly come down, it is mainly because these developers are able to accurately evaluate and appreciate the underlying cash flow streams. These bidders were more than happy to enjoy the outsized returns in a high tariff regime, but also understand that lower tariffs may mean lower returns but that is not the same thing as negative or irrational returns. In fact NTPC’s chairman has just gone on record stating that a per unit solar tariff of Rs. 3.0 - Rs. 3.2 may be the new normal, and significantly, it can be achieved “without relying on cheap funds or compromising on quality”.
Those who erroneously claim that low cost of foreign capital is driving down tariffs to irrational levels very often appear to be ones who have been caught sitting on the sidelines while developers who understand the risk & return trade off for solar continue to grow, develop, attract capital and generate value for shareholders.
Author:Gagan Sidhu -Renewable Energy Finance/ Investment Banking Professional