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The Viewpoint Presidential Directive to Ease Coal Supply

The Viewpoint Presidential Directive to Ease Coal Supply

Bar & Bench

By Neeraj Menon and Lzafeer Ahmad 

The nationalization of coal mines in the year 1973 paved the way for the Government of India to assume the responsibility of managing the coal mines through Coal India Limited (CIL) and its subsidiaries. The objects clause of the Memorandum of Association encapsulates the role of CIL and provides that it must act “as an entrepreneur on behalf of the State in respect of the coal industry and plan and organize production of coal as also its beneficiation and the manufacture of other by-products of coal in accordance with the targets fixed in the Five Year Plans and the economic policy and objectives laid down by the Government from time to time”.

In the past few years, the energy sector has faced severe energy deficit, primarily due to shortage of coal supply which has restricted the ability of power companies to generate to their full capacity. The deficient coal supply has impaired the interests of various stakeholders in power projects as they are unable to meet their power supply commitments under the power purchase agreements (PPA) with off-takers.

Presidential Decree: Basis

In order to address this uncertainty over coal supply, the Ministry of Coal directed CIL and its subsidiaries to enter into fuel supply agreements (FSA) by 31 March, 2012 for projects commissioned after 31 March, 2009 and those scheduled to be commissioned by 31 March, 2015. The direction applied to projects that had entered into a long term PPA with distribution licensees. However, CIL did not adhere to these directions as the independent directors of CIL strongly opposed the move and there was a lack of consensus. Consequently, a decree was issued by the President of India on 3 April, 2012 directing CIL to give effect to the Ministry’s directions.

Article 37 of the Articles of Association of CIL vests the power in the President to issue directives in relation to the conduct of the business of CIL in matters affecting public interest. Article 53 of the Constitution of India explicitly provides that the President can exercise  executive powers and issue any directives as long as they are not in violation of the Constitution. A presidential directive does not require any prior legislative support. However, it may be challenged in a court of law on the grounds of it being unconstitutional, contrary to the provision of any law, infringing upon the legal rights of an individual, etc.

Likely Impact of the Decree

The decree obligates CIL to sign FSAs with power producers, undertaking a supply commitment of 80% of the contracted quantity of coal required by the power producers. It requires CIL to enter into FSAs with all power producers who have entered into long term power purchase agreements with distribution licensees and have commissioned their projects between 31 March, 2009 and 31 December, 2011. In the event of the supply being less than 80%, CIL is required to either, pay a penalty or satisfy the deficit in domestic coal with imports. The decree also proposes incentivizing supply by CIL of over 90% of the contracted quantity. The proposed commitment on quantum of supply is in stark contrast to the situation existing prior to the presidential decree, where CIL was required to meet only 50% of the assured quantity.

The directions mentioned in the decree poses immense challenges for CIL in terms of making available the capacity to meet the demand. The aggregate demand under the FSAs, when signed, is likely to exceed CIL and its subsidiaries’ current and near future production capacities. In the likely event of a shortfall in the supply of domestic coal, CIL might have to, in order to avoid payment of penalty, import coal to meet its supply commitment under the proposed FSAs. If CIL chooses to import coal, it may transfer this cost to the project developer who in turn, depending on the terms of its PPA, may or may not be able to claim the increased cost of fuel as a tariff pass through from the distribution licensees. The cost and viability of a coal fired project is estimated on the basis of the pricing under the fuel supply agreement, meaning that the import of coal would expose the project developer to the risk of price volatility rendering it impossible for the developer to produce and deliver power on the basis of the tariff bid under the PPA. Alternatively, since the proposed penalty on CIL for shortfall in supply is only 0.01% of the value of the deficit committed supply of coal, it is possible that CIL may consider payment of penalty to be a more viable option as opposed to importing expensive coal. In such a scenario, the abysmally low penalty rates would act as a buffer for CIL as it could forego meeting its supply obligations using imported coal.

Decree beyond its mandate?

The Presidential decree undermines the rights and fiduciary duties of the directors of CIL’s board, especially the independent directors, who are forced to give effect to the decree against their fiduciary duties of acting in the interest of the company. Since it is highly unlikely that CIL would be able to meet the aggregate supply commitment, CIL would be incurring financial risks under the FSA, both in terms of payment of penalty or in importing expensive coal. While the freedom to choose the penalty rates is likely to comfort the directors, they are forced to proceed with a commercial decision which they had earlier opposed (i.e. the signing of FSA with an 80% supply commitment). Moreover, it will impact the interests of the minority shareholders of the company. In fact, a minority shareholder in CIL, The Children’s Investment Fund Management (UK) LLP (TCI) has announced that they propose to take legal action against CIL and its directors for approving signing of the FSAs. TCI has alleged CIL of selling coal at a price below the market price, hurting the interests of the minority shareholders.

Concomitantly, the legality of the presidential directive needs to be examined. The lack of a judicial precedent on the legality of presidential decree in relation to the management of a company has not helped the situation. The Articles of Association of CIL empower the President to issue a directive if there is an element of public interest involved. To what extent signing of the FSAs for supply of coal at subsidized rates is in public interest as much as it is a commercial decision, is subject to debate. If the increased cost of fuel incurred by CIL is ultimately to be borne by the end user as a tariff pass through, subject to it being permitted under the PPA, the element of public interest may be questioned. In the event the PPA does not allow increased cost of fuel as a pass through, the additional financial burden on power producers may affect bankability of the projects.

Finding a middle ground

In a nutshell, it is imperative that CIL undertakes certain measures to mitigate the likely harm of this presidential decree over the stakeholders of the company. As a first step, CIL should define the term “long term PPAs” as mentioned in the decree. This will restrict applicability of the decree and CIL’s obligation to sign the FSAs with projects that have entered into PPAs with distribution licensees for a minimum term of certain years. This essentially translates into disentitlement of the off-grid power projects to an assured supply of coal under the FSA.

Another step that CIL could adopt is to interpret “demand of power producers” under the FSA by linking the annual contracted quantity under the letter of assurance to contracted capacity tied up under the PPA, i.e. CIL would be obligated to supply coal proportionate to the contracted capacity under the PPA instead of the project’s nameplate capacity. Effectively, where a power project has a capacity of say 1000 MW but has a long term PPA with a distribution licensee for supply of only 300 MW, CIL would be obligated to provide coal required for production of the PPA capacity as opposed to capacity being used for captive purposes or merchant sale. While this might in the short term help CIL to meet the demands through its current reserves and scheduled capacity addition, more substantive measures of implementing global standards in mining processes may be the way forward to reduce costs and improve efficiencies.

The need of the hour is for CIL to adopt measures that provide an equitable treatment to the interest of various stakeholders while taking into account the larger public interest of assuring fuel supply to meet the Government’s ambitious aim of making power available to all by 2012.

Neeraj Menon (pictured right) is a Counsel and Lzafeer Ahmad (pictured left) 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.