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The Viewpoint – Competing for Idle Capacity How Coal Supply issues are Derailing  Thermal Power Projects in India

The Viewpoint – Competing for Idle Capacity How Coal Supply issues are Derailing Thermal Power Projects in India

Bar & Bench

Fuel shortage being faced by power project developers in India is adding significantly to the woes of the power sector, given it is already grappling with challenges of land acquisition and environmental clearances. Both domestic and global power companies are reassessing their expansion plans in India, and considering investments in other jurisdictions due to the increased risk profile of investing in an Indian power sector beleaguered by fuel shortages. With domestic coal and gas production failing to keep up with capacity addition targets, it is unlikely that fuel supply constraints faced by power producers will ease off in the near future. Further, the ability of power producers (especially under the competitive bidding route) to mitigate the effects of fuel supply shortage and increased cost of fuel is also limited by the contractual framework under the Competitive Bidding Guidelines issued by the Ministry of Power (MoP).

In this article, we have analysed the contractual framework governing power off-take and fuel supply arrangements for thermal power projects set up under the competitive bidding route, identified some of the inherent inadequacies in the risk allocation and highlighted the key operational issues being faced by project developers.

Legal and contractual framework for establishing IPPs in India

Before discussing how fuel supply constrains are affecting power producers, it is important to understand the typical power off-take arrangements. Off-take arrangements from independent power projects (IPPs) depend upon the scheme under which the IPP is being set up. Broadly, there are three options available for setting up an IPP – as a merchant plant, under the negotiated route, or pursuant to a competitive bidding process. Under the first option, the power producer does not enter into long term off-take arrangements, and instead sells power on a short-term basis on the spot market or through a power exchange. Under the second option, a memorandum of understanding (MoU) is negotiated and executed with a state government for setting up the project within its jurisdiction. This route is often referred to as the MoU route. The third option is to bid for an identified project envisaged under the Competitive Bidding Guidelines.

Power procurement in the Indian market is increasingly being done through competitive bidding. The MoP, in January 2011 notified that all long-term power procurement by state governments and distribution companies should be through competitive bidding under the Competitive Bidding Guidelines.

Under the Competitive Bidding Guidelines, there are two prescribed models (i.e., the Case 1 route and the Case 2 route) under which development of a power project is envisaged. Under the Case 1 route, the project developer is responsible for arranging consents, land and fuel for the power project. On the other hand, under the Case 2 route, the procurer undertakes to bear higher risk by arranging land and fuel linkages for the project. The Competitive Bidding Guidelines, for both Case 1 and Case 2, require bidding by the project developer on the basis of a levelized annual tariff and the winning bidder is required to execute a standard form power purchase agreement (standard PPA) in the format issued by the MoP.

While the effect of the introduction of competitive bidding has by and large been positive, the lack of flexibility available to power producers under the contractual framework set out in the Competitive Bidding Guidelines to counter market changes and operational issues (such as coal shortage or increase in coal price) is limited, leading to a significant risk of default by project developers.

[Un]Assured domestic supply and increased costs of imported coal – a double whammy

Under competitive bidding, bidders require considerable certainty on price and availability of fuel in order to be able to accurately price their bids. However, obtaining an assured domestic coal supply arrangement is becoming a significant challenge. Coal allocation is granted by the Ministry of Coal, (MoC) either under a long-term or a short-term linkage. For obtaining a long-term coal linkage, a project developer is required to make an application to the MoC which may issue a letter of assurance (LoA). On fulfillment of milestones set out in the LoA, the power project developer usually executes a standard form fuel supply agreement (standard FSA) with a government owned coal producer (e.g. Coal India Limited).

Usually in most international power purchase agreements (PPAs), 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 position in India does not reflect this, both vis-à-vis fuel supply certainty and pass-through of increased fuel costs.

Domestic supply constraints and inadequate risk allocation

Under the standard FSA, the coal supplier only guarantees up to 50 percent of the normative coal requirement, which (to state the obvious) is a significant risk for the project developer. IPPs under the Competitive Bidding Route are entitled to full capacity charges only if the plant operates at ‘normative availability’ (i.e., at 85 percent according to the current tariff regulations). To the extent the actual availability falls below a pre-agreed threshold, the power producer is also required to pay a penalty to the power purchaser under the standard PPA (up to 20 percent to the extent of shortfall in the capacity charge) and the PPA can even be terminated by the power purchaser if actual average availability falls below 65 percent of the normative availability for a specified period. There is, as such, no relief available to the power producer under the standard PPA if it cannot achieve the normative availability due to short-supply of fuel by the fuel supplier.

As it stands, unless a power producer is able to procure an alternate source of supply cheaply and quickly (both of which may be unachievable), not only does the power producer run the risk of reduced revenues and penalties, but it also risks its PPA being terminated altogether for reasons wholly outside its control, i.e., the coal supplier’s failure to provide the required quantity of coal for the project, with effectively no recourse against the coal supplier. As is clear, there is an inherent mismatch between the obligations/liability (or to put it differently, the lack thereof) of the coal supplier for failure to supply coal under the standard FSA on the one hand, and the obligations and (rather dire) consequences for the power producer under the PPA for not being able to operate the plant at the requisite availability levels, which is a big cause of concern for project developers.

No pass-through of increased cost of imported coal

Given the domestic coal supply constraints and the resultant inadequacies in risk allocation, various project developers have sought to source imported coal either through long term long arrangements or by bridging shortfalls in domestic supply. In either case however, project developers are facing an exponential increase in fuel supply costs due to the recent surge in international coal prices coupled with minimum price controls introduced by foreign governments, which are both outside the control of the power producer.

As mentioned earlier, an increase in fuel price is often passed through to the power purchaser (who in turn passes the incremental costs on to the ultimate customers) as it would be seen to be unfair to expect the power producer to bear the repercussion of increase in costs due to reasons outside its control. Also, it is felt that the incremental increase spread out over the numerous customers (the ultimate users of the electricity generated) would be significantly less onerous when compared to the potential hardship suffered by the power producer bearing the entire increased cost. However, the PPAs entered into in relation to the IPPs under the Competitive Bidding Route do not allow for pass-through of increased fuel costs. As a result, most power producers relying on imported coal will likely incur significant losses if they were to operate their plants on the basis of the tariff agreed under their respective PPAs, which is clearly not a sustainable model or one that encourages foreign and domestic investment.

Re-thinking required

As is evident from the above discussion, there is a clear mismatch between the Government’s aspirations for capacity addition and its policies or lack thereof for encouraging private investment in the sector. In order to bridge this gap, the Government could consider the following measures:

  • The standard FSA should capture the essence of the New Coal Distribution Policy, 2007 – and coal suppliers (such as Coal India Limited) should be required to make a firm commitment to supply 100 percent of the normative requirement or compensate the power producer.
  • To the extent a 100 percent supply commitment cannot be given, the power producer should be excused from performing its obligations under the standard PPA to the extent of non-supply by the fuel supplier (for reasons outside the power producer’s control). The normative availability requirement should also be reduced accordingly so that the power producer does not suffer any economic loss as a result of non-supply of coal.
  • Allowing a straight pass-through of any fuel price fluctuations under the PPA (to the extent such fluctuations are due to reasons outside the power producer’s control). This could be done by amending the Competitive Bidding Guidelines to provide for bidding based on capacity charge and heat rate, and provide a pass-through mechanism pursuant to which fuel price fluctuation are to the cost/benefit of the power purchaser who could pass on the same to its end consumers.
  • Increased fuel cost aside, it is quite likely, during the course of performance of a long term contract such as the standard PPA, there may arise other events which are neither foreseeable nor under the control of either party, which may nonetheless render performance of the contract excessively onerous, thereby causing hardship to either or both parties. In light of this, the Government could consider inserting a ‘Material Adversity’ clause to the standard PPA which would be based on the doctrine of hardship (followed in various civil law jurisdictions) to address events which fundamentally alter the equilibrium of the PPA. Such a clause could be based on the UNIDROIT Principles of International Commercial Contracts, 2004 which embodies the doctrine of hardship.

Avirup Nag (pictured left) is a Senior Associate and Suhas Baliga (pictured right) is an Associate with Trilegal.

Trilegal is a full-service law firm with offices in Delhi, Mumbai, Bangalore and Hyderabad. The firm has over 120 lawyers, some of whom have experience with law firms in the US, the UK and Japan.