Coal supply pacts lack substance

By Kameswara Rao

It is hard to recall another commercial contract that has attracted as much impassioned debate as Coal India’s (CIL) fuel supply agreements (FSA). The unusual step of presidential directive, vocal stance of minority shareholders and terms of the agreement itself have all contributed to the high-voltage drama.

The underlying business of production and supply of coal to power plants on a regulated basis is as old as the mines. So what has changed? Shortages have become more acute with many power plants running low coal stocks and risking shutdown and imported coal, an increasingly inevitable substitute, is costlier.

Investment in new power generation is increasingly coming from the private sector that is more commercially alert, and power plants are increasingly refinanced by overseas capital. The FSA debates, hence, reflect the challenges of moving the primary fuel chain into commercial arrangements and real decontrol.

Changes are not easy to usher in at short notice and the current tussles reflect practical and institutional challenges of transforming a monopoly state-owned entity. A reasonable transition period is necessary for internal changes to take root, as CIL will need to reorganise its operations and administration, strengthen its mine planning and mine development activities, revise its rate-contracts with service providers and staff incentive systems to orient to the new demands.

The modified model FSA put up by CIL is a useful starting point, and doubtless, the current provisions would benefit significantly by an honest debate between the supplier and consumers. Let’s look at some of the prominent issues involved, and the implications that go beyond the FSAs.

The quality and quantity supplied remain a challenge. The FSA specifies but does not pin down to a specific grade or delivery system, and, in fact, is left open for modification at any point. It means that power plants risk bearing cost of uncompensated grade slippages and thermal inefficiency, and the only alternative is contract termination without liability.

The supply of ungraded coal (gross calorific value less than 2,200 kcal per kg) is another potential risk – the coal itself is nominally priced, but the purchaser ends up paying more royalty at the specified grade and freight charges.

The compensation for shortfall in quantity is currently set at 0.01% of the base price below 80% level, which translates into (say, for E-grade equivalent) less than 1 per tonne of coal or barely 0.05 per kWh of loss of generation, a minuscule amount in contrast to a potential large stranded capital cost for shortfall below normative levels.

The stranded cost can hit a newly-commissioned plant too if its designated supply has not achieved precedent conditions. The proposed transition period of three years could be used for internal reforms that give CIL confidence to bear more meaningfully-structured penalties after that.

The logistics of coal transport pose several issues to be addressed, and separate transport service agreements will be necessary. The current FSA leaves the purchaser liable for payment for rakes that are delayed or missing and coal not received at the power plant, although it is not clear if the clause is limited to purchaser’s default as it appears.

The transport cost borne is for the actual route and not normative, which means distant power projects suffer a significant uncertainty as freight can be 30-40% of the total cost. The overloading penalty too is borne by the purchaser, although the loading is at the mines and the collieries are best placed to manage it at their loading points.

Logistics and transport services agreements, such as with the railways, are clearly the next issue to address.

Import of coal is provided as an option to cover shortages on a cost- and risk-neutral basis, i.e., a back-to-back agreement. It is not clear how imports will be sourced and, so, the cost implications are unclear, although the procurer can decline the option without any penalties. The import option may not be any better than direct procurement by utilities, where they have better visibility of the terms, quality and pricing.

The pity is that the import provision could have been structured to drive strong economies of scale in procurement. Private power projects that have acquired captive coal assets overseas face a tsunami of resource nationalism, with exporting countries levying super-profit tax, export tax, carbon cess, imposing domestic supply obligations, transfer pricing and equity/profit share requirements, besides investments to be made in infrastructure development.

The FSA and the directives to sign them are not likely to achieve much unless the real commercial destination is visible. This is currently missing, and even after that, other actions are necessary to truly reform coal supply– namely, enhance competition in coal production by opening it to new suppliers, and to amend the 1973 Act to permit a third route other than government dispensation or captive dispensation, in effect, opening up coal to independent mining and domestic trading, even if in a phased manner.

(The author is leader for energy, utilities and mining at PwC India)

Source: ET


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