Power Sector: Is it heading towards another collapse? Bernstein answers

The Indian power sector has been experiencing significant growth, but with the awareness that this growth is cyclical and could eventually come to an end, said brokerage Bernstein in a recent report. Despite potential challenges, it maintains a positive outlook, considering it to be in its early stages and continues to like NTPC, PowerGrid and ReNew to invest in the cycle.

The brokerage is overweight on NTPC, PowerGrid, and ReNew while retaining an underweight rating on IEX and Adani Green.

In the report, the brokerage delved into the previous cycle to understand its collapse and identify key indicators for the current cycle.

As per the brokerage, one of the most telling signs of a downturn in the power sector is the movement of merchant power prices. In the previous cycle, these prices peaked at ₹8.4 /kWh in April 2009 before plummeting, dragging down the entire sector including utilities, equipment providers, and financiers, it noted.

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The downfall of the last cycle can be attributed to various factors, primarily stemming from the initial phase of privatisation, stated Bernstein. Amidst a landscape dominated by government agencies and influenced by political agendas, the sector was buoyed by easy financing from banks and NBFCs, leading to its eventual collapse. The sequence of events unfolded as follows:

The rise: In 2003, the Indian power sector underwent deregulation, signaling a shift towards privatisation. This move paved the way for significant developments, including the establishment of the first major private power plant by JSPL in 2008, which boasted an impressive return on equity (ROE) of around 200 percent. During this period, the nation was grappling with a substantial power shortage of 17 percent.

The enthusiasm within the sector was palpable, exemplified by the overwhelming response to the Reliance Power IPO in January 2008, which was subscribed by a staggering 73 times. This fervor spurred a rush of investment as players eagerly sought to capitalise on the burgeoning opportunities.

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The process for entering the market was relatively straightforward: companies would sign Memoranda of Understanding (MoUs) with state governments, leveraging these agreements to secure land for their projects. Subsequently, they would utilise the MoUs to obtain financing from banks, often inflating project values to draw additional funds. With financing secured, companies would then proceed to award Engineering, Procurement, and Construction (EPC) contracts, initiating construction activities.

However, the execution of projects was marred by challenges, particularly in the realm of coal procurement. Many projects faced prolonged delays in obtaining coal supplies, leading to uncertainties and disruptions in operations. Moreover, the strategy of relying on merchant sales, where electricity is sold on the open market, proved to be fraught with risks, especially as prices later experienced a sharp decline.

This period witnessed a frenzied rush into the sector, driven by optimism and the allure of lucrative returns. However, the reality of operational challenges and market volatility soon became apparent, underscoring the importance of prudent planning and risk management in navigating the complexities of the power industry.

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Demand-side woes: The demand-side challenges in the power sector were characterised by several factors, including the disparity between power growth and GDP growth, as well as the distressing state of DISCOMs, said the brokerage. Firstly, the growth rate of power demand consistently lagged behind that of GDP during FY10 and FY11. While GDP was growing at an average rate of 9 percent, power demand only grew by 5 percent. This discrepancy was primarily driven by a slowdown in industrial activity. Furthermore, the emergence of additional captive generation capacity further reduced the reliance on grid power, exacerbating the situation, it pointed out.

Secondly, the state of DISCOMs during the previous cycle was dire. Under-recovery, which refers to the shortfall between the cost of supplying electricity and the revenue collected from consumers, skyrocketed to 21 percent of the cost of supply in FY12. This was a stark contrast to the relatively healthier state observed in FY22, where under-recovery stood at a mere 2 percent. The financial distress of DISCOMs was so severe that they resorted to load-shedding rather than purchasing power, even when it was available in the market, stated the brokerage.

These demand-side woes had significant implications for the power sector, leading to underutilisation of existing capacity, financial strain on DISCOMs, and disruptions in power supply. Addressing these challenges required comprehensive reforms aimed at improving the efficiency and sustainability of power distribution, as well as stimulating industrial growth to drive demand for electricity.

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Supply-side woes: The supply-side challenges in the power sector were multifaceted, encompassing issues related to coal scarcity, over-supply, grid limitations, and railway constraints, noted the brokerage. It lists 4.

Firstly, coal scarcity posed a significant problem, with coal production growing at a sluggish 4 percent CAGR from FY07 to FY17, while coal generation capacity expanded at a much faster rate of 10 percent in the same period. This disparity forced companies to resort to importing coal or reducing their plant operations. The situation was exacerbated by a sharp increase in imported coal prices, rising by approximately 100 percent between May 2009 and January 2011, compounded by rupee depreciation.

Secondly, an over-supply of thermal power plants loomed on the horizon, with approximately 90 GW of under-construction capacity against an installed base of 102 GW in FY10. Despite this growth, dispatchable power supply surged at a CAGR of 11% from FY09 to FY16, outpacing power demand growth, which stood at 5% in the same period.

Moreover, India's grid infrastructure presented significant challenges, particularly in transmitting power to the southern regions. The asynchronous nature of the grid complicated power distribution, resulting in higher prices and shortages in the south compared to the rest of the country. For instance, in March 2011, average power prices in the south reached Rs. 9/kWh, significantly higher than the national average of Rs. 3/kWh.

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Lastly, railway constraints further compounded the coal scarcity issue, hindering the transportation of coal from production centers to power plants. For instance, coal plants in Chhattisgarh faced difficulties in obtaining coal linkages and were directed to import coal from the west coast due to railway constraints in the east.

Despite these challenges, Bernstein believes the current cycle appears less susceptible to failure due to diminished risks in DISCOM health deterioration, over-supply, coal availability, and grid constraints. However, potential risks lie in slower-than-expected demand growth and disruptive advancements in battery technology.

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In conclusion, while the power sector remains promising, vigilance is essential. Monitoring demand trends, battery economics, and merchant power prices will be crucial in identifying warning signs, it said.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decision.