The Role of Risk Allocation in Transaction Design: The Case of Power Distribution

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1 The Role of Risk Allocation in Transaction Design: The Case of Power Distribution Allen Eisendrath & Fraser Morrison Deloitte Emerging Markets February 26, 2003

2 Agenda Investors View of Electricity Distribution Investment Overview of Karnataka s Electricity Sector Exercise 1: Assigning Risks Transaction Description Exercise 2: Calibration of the Transaction Discussion

3 Distribution Business Risks are High Few investors want distribution assets because: Huge, growing operating losses Tariffs below cost recovery Large distortions in tariff structure Condition of assets and customer base is unknown Major problems with theft & customer resistance Uncertainty about evolution of tariffs Uncertainty about demand Investors lost in Orissa and in many IPPs New electricity sector design is unknown

4 Distribution Profit is Highly Leveraged BREAKDOWN OF KARNATAKA'S ELECTRICITY COST Percentage of Total Cost to Deliver 120% 100% 80% 60% 40% 20% 2% 23% 5% 70% Distribution Profit Distribution Cost Transmission Cost Power Purchase Cost 0% Type of Cost

5 Sceanarios Assumption for the Period FY2001 to FY 2006 Base Case Scenario Cumulative Funding Gap from FY2001 to FY2006 (Nominal) Cumulative Distribution Equity Returns from FY2001 to FY2006 (Nominal) Return on Capital Base Rupees Rupees Base Case 5,061 16% Tariff Risk Tariff growth at a CAGR of 12% Tariff growth at a CAGR of 11% 13,051 (7,617) (17%) Demand Risk Agriculture demand growth at 3% p.a. HT demand growth at 5% p.a. Agriculture demand growth at 5% p.a. HT demand growth at 2% p.a. 10,360 (4,880) (11%) Collection risk Collections at 100% Collections at 95% 19,169 (13,885) (30%) T&D loss level Starting loss level at 36.5% reducing at 2.25% per annum Starting loss level at 45% reducing at 2.25% per annum 53,290 (48,229) (105%)

6 It Takes Time to Rebuild the Sector Expectations for privatisation cannot be fulfilled immediately Privatisation requires transfer of risk from public to private sectors, but we cannot transfer risk immediately because the operators need time to: Rebalance tariffs Reduce losses Comply with safety, performance and information requirements

7 Overview of Karnataka s Electricity Sector

8 Overview of Karnataka s Electricity Sector Installed Capacity: 4,292 MW Area covered: 191,791km 2 Number of consumers: 10 million Total consumption in : 01: 17.5 MU

9 Overview of Karnataka s Electricity Sector BASIC FINANCIAL DATA Rs. Billion US $ Million Revenue $692 Subsidy $ $ $408 Receivables 15 $313 Payables for Power Supply 16 $333 Estimated T&D Loss Value $398

10 Overview of Karnataka s Electricity Sector AVERAGE COST & REALIZATION FOR Rs./kWh US cents/kwh Average Realization per Unit Generated cents Average Agricultural Tariff Realization cents Average Cost of Supply inc. Distribution cents Average Power Purchase Cost cents METERING & LOSS LEVELS % of energy input % of Metered Consumption 37% Official Estimate of Combined Losses 38%

11 Overview of Karnataka s Electricity Sector KPCL Total 1.03 CGS & Other States Total 1.78 Transco O&M 0.03 Depr 0.02 Interest 0.03 Trans Loss 0.12 Tax+ROR 0.01 Total 0.21 Numbers are Rs./kWh Exchange Rate: US $1 = Rs. 48 G Avg Cost T Avg Cost D Rs.1.36 Rs.1.57 Avg Cost of Supply Rs.3.07 VVNL FY IPPs & Co-gen Total 2.57 Cost Coverage: 2.03 average realization / 3.07 average cost = 66% cost recovery

12 Reform Process So Far Electricity Reform Act Passed 17% tariff increase approved by KERC MOA with Central Government on Reforms Financial Restructuring Plan Approved Anti theft law passed 4 Distcoms formed Privatisation Strategy Published Distribution Privatisation Planned

13 Investors know that transition is risky. Unlike England & Wales, Australia, Argentina, Chile GoK has postponed the day when consumers face cost reflective tariffs Transition Point Transition Period Operating losses decline Operator receives strong incentives to turn the system around and to collect and provide key information Rates are predictably rebalanced Customers are brought back into the system Regulatory rules work Lenders and investors don t lose money Post-Transition Period Incentive-based cost of service regulation established Cost recovery rates charged Operators compensated for financial costs associated with subsidies Collection & theft enforcement allowed Full information on system status and performance available

14 Expected Investor Behavior In highly risky situations, operators seek to minimize cash commitments and demand protection from uncontrollable risks

15 Workshop Exercise 1: Assign the Risks

16 Karnataka Transaction Summary

17 Karnataka Transaction Summary Move from a non-viable to a viable sector structure Allow a reasonable transitional period Provide incentives for technical and commercial loss reduction Avoid red ink in early years Achieve realistic hurdle rates Allocate risks to those who can control and afford them

18 Karnataka Transaction Summary Wires business unbundled, like the UK model with a reasonable transition period minimum cost to enter the market high probability of recovering opex and capex in the transition period and a conventional incentive-based cost of service regulatory approach after transition.

19 Karnataka Transaction Summary Private sector operator owns and runs distribution business. Operator earns a Distribution Margin (DM) as compensation for operating the network Base Revenue: : 100% of new operators expected operating cost, capital expenditure and minimum equity rate of return. Incentive Charge: Paisa per rupee collected above Minimum Collection Requirement (MCR) Minimum Collection Requirement (MCR) is minimum cash to be collected by the Operator Operator must: Meet service standards Provide specified information Operator has penalties if they do not meet MCR & Service Standards

20 Karnataka Transaction Summary Comprehensive wholesale and retail allocation rules Allocation of wholesale electricity between Discom Minimum supply to consumer categories Allocation of electricity shortfalls and additions Transition tariffs will be rebalanced and increased to cost recovery After transition period (3-5 5 years), an incentive-based cost of service regulatory system will apply, using a multi-year tariff and independent setting of efficiency improvement requirements

21 Karnataka Transaction Summary: Estimating the Required Transitional Tariff Rupees Per Unit 3.07 Transition Date Loss or Subsidy Average Tariff 2.03 Average Cost of Service

22 SUMMARY DESCRIPTION OF THE DM FINANCIAL STRUCTURE GoK PAID BY GOK Subsidy Requirement Condition Of Assets Service Standards Financing Costs Distribution Opex SET BY DESIGN BEFORE BIDDING Base Revenue Distribution Capex Including 4% ROE Incentive Charge SET BY REGULATOR Transmission Cost Generation Cost DM Charge Total Costs Gross Revenue SET FOR TRANSITION PERIOD Average Tariff Units Collected Allocation Rules Financial Driver or Input Minimum Collection Requirement SET BY DESIGN BEFORE BIDDING Technical Losses Aggregate Loss Commercial Losses Wholesale Units Received

23 Karnataka Transaction Summary Terms of Award GoK will sell 51% of the equity share capital of Discom Equity offered at par value Equity sold to bidder offering lowest Incentive Charge

24 RISK ALLOCATION SUMMARY TABLE RISK TYPE ALLOCATION MECHANISM Collection Risk Shared by distribution operator and Government Minimum Collection Requirement & Incentive Charge.. Capital Expenditure Risk Operator Base Revenue. Operating Cost Risk Operator Base Revenue. Tariff Risk Shared by operator and Government. Fixed multi-year tariffs. Wholesale Supply Risk Shared between distribution operator and Government. Minimum Collection Requirement and Incentive Charge Put-or-pay contracts Wholesale Price Risk Government Financial Balancing Mechanism Transmission Services Risk Transmission Charges Risk Shared between operator and Government Government or KPTCL bears this risk Minimum Collection Requirement & Incentive Charge Transmission services agreement Financial Balancing Mechanism Total Demand Risk Shared between distribution operator and Government Minimum Collection Requirement & Incentive Charge. Customer Category Demand Risk Government Subsidy Risk Shared between distribution operator and Government Shared between Single Buyer and Transmission Operator Base Revenue, Minimum Collection Requirement & Incentive Charge Base Revenue Regulatory Risk Operator Minimum Collection Requirement & Incentive Charge. Partial Risk Guarantee

25 Government is the seller and must decide final terms of the deal. This calibration will determine exact risk allocation. Options include: Set Base Revenue and Minimum Collection Charge at levels that attract strong competition. Fix retail tariffs for the entire transition period. Provide reasonable government support for collection and operator s s private property Cap return on equity. Establish clear regulatory rules and procedures for DM and the post-dm period. Cap electricity supply to low tariff customers.

26 Workshop Exercise 2: Calibrate the Transaction to Finalize Risk Allocation

27 Step 1: Set Base Revenue? 120% 100% -90% -70% Return on Equity Capex Incentive Charge Base Revenue Opex

28 Step 2: Set MCR? 130% 100% New Collections Last Year s Collection Level Minimum Collection Requirement (MCR)

29 Summary of Recommendations More favorable to investors More favorable to investors POSSIBLE VALUES FOR CALIBRATING BASE REVENUE AND MCR Increase in Gross Collection Return on Equity 0% 10% 30% 16.00% 10.00% 6.00% 0.00% %

30 Session Wrap Up

Power Sector Reform India The Long Road Ahead

Power Sector Reform India The Long Road Ahead Rahul Tongia Department of Engineering & Public Policy/ School of Computer Science University February 19, 2003 2 Outline Overview of the Indian power sector