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Utilities

India

ATTRACTIVE
JULY 02, 2013 UPDATE BSE-30: 19,464

What to expect from CERC in 2014-19? CERC has released its approach paper for the purpose of inviting opinions, for determining the tariff regulations for the period FY2014-19E. While the approach paper is not conclusive, it gives an indication of the areas of tariff determination to be addressed by the regulator. We remain constructive on regulated utilities and believe the review will address key issues hindering the progress of the sectorwhile maintaining a balanced approach between return profile for the utilities and tariffs for the consumers.

CERC invites comments on a wide range of issuesfrom capital costs to operating parameters CERC has invited comments from stakeholders on varied components of the tariff structure. While the observations on capital cost and return on investments appear to have a negative-bias, they are compensated by potentially lower normative availability parameters and inflation-linked maintenance costs. We enlist key areas of the tariff component and observations by the regulator open for comments/suggestions; Exhibits 1 and 2 put in detail the key features of the approach paper. ` Capital costs. CERC has invited comments on (1) prescribing standard construction period (and consequent interest during construction), and (2) mandatory international competitive bid for award of plant packages to ensure timely and cost-controlled execution of power projects. CERC has further deliberated on (1) increasing the useful life of projects to reflect the true life (from current 25/35 years for generation and transmission projects), and (2) considering residual useful life before allowing substantial renovation capex. ` Return on investment. CERC has invited comments on (1) change of return parameters from RoE to RoCE, (2) reduction in regulated equity to reflect depreciated asset value (as opposed to gross value currently), (3) adopting a market-linked rate of return on equity or reduction (as opposed to standard 15.5% currently prescribed), (4) differential rate of return for thermal, hydro and transmission assets, (5) retention of tax benefit u/s 80-IA by the generating company, and (6) possible introduction of a normative rate of interest based on certain benchmarks. ` Maintenance expenses. CERC has proposed a mechanism of an inflation-linked indexation of operation and maintenance costs (including an efficiency factor to reduce reimbursement) that better reflects cost than a fixed indexation (5.7% currently). ` Variable charges (and operating parameters). CERC is seeking comments on (1) whether existing norms on station heat rate can be strengthened, and whether there is any scope for altering other operating parameters (auxiliary consumption, secondary fuel oil), (2) whether plant availability (PAF) needs to be reviewed keeping in mind the conditions of fuel shortage, and (3) proposal for prescribing a normative blending ratio in view of the persistent shortages in domestic coal supply. Past experience has shown a balanced, progressive outcomewe remain constructive We remain positive on regulated utilities such as Powergrid (TP: Rs140/share) and NTPC (TP: Rs175/share) which have demonstrated improved execution and are trading at the lower end of the historical multiples. Past experiences from a regulatory review has shown that while operating parameters are tightened, they have usually been compensated through a better incentive and return profile, yielding a balanced outcome. In our view, the current tariff review also looks to address key concerns around the power sector without dramatically altering the return profile.
Murtuza Arsiwalla
murtuza.arsiwalla@kotak.com Mumbai: +91-22-6634-1125

Avinash Ranjan
avinash.ranjan@kotak.com Mumbai: +91-22-6634-1406

Kotak Institutional Equities Research kotak.research@kotak.com Mumbai: +91-22-6634-1100 For private Circulation Only. FOR IMPORTANT INFORMATION ABOUT KOTAK SECURITIES RATING SYSTEM AND OTHER DISCLOSURES, REFER TO THE END OF THIS MATERIAL.

India

Utilities

PAF, PLF and fuel pricesthe incentive juggernaut


We deconstruct the incentive juggernaut under extant regulations to assess the impact of key operating parameters to project returns, in light of the increasing shortage of domestic fuel supplies (an area of concern highlighted even under the approach Paper to Tariff Regulations). ` PAFwhile offering a lower quantum of absolute savings (due to low historical capital cost), has a higher sensitivity to returns as it can take away from base RoE as well. ` PLFfuel cost savings are function of efficiencies and coal prices, remunerated for actual generationmeasured decline in PLFs will not lead to substantial erosion of returns. ` Fuel pricesas the fuel efficiencies (normative consumption actual consumption) are compensated at the actual price of coal, higher blended cost of coal is return accretive.

Alternative tariff design mooted to ensure long-term predictability


CERC has explored the possibility of an alternative tariff design to ensure long-term predictability of a projectas opposed to five-year regulatory review. The alternative tariff structure moots two components for the fixed tariff(1) first component linked to a predetermined degression curve for the entire life of the plant (to factor reducing interest and depreciation), and (2) second component indexed to CPI and WPI (reflective of rising maintenance costs). While CERC highlights critical issuesnot passing benefits of change in market factors (like lowering of interest rates) to consumers and the treatment of replacement and maintenance capital expenditure under this approach, we see limited likelihood of this approach progressing further since this would mark a drastic change in basic approach of tariff design.

KOTAK INSTITUTIONAL EQUITIES RESEARCH

Utilities

India

Exhibit 1: Most of the proposed changes in the financial norms either neutral-to-negatively biased Existing regulations and CERCs comments on various financial parameters of tariff setting in the approach paper dated July 2013
Capital cost Existing Capital cost based on projected capital expenditure to be revised based on actual cost incurred subsequently. Provision for meeting expenditure on R&M for extension of useful life. Enough cash flows to meet the repayment obligations during first 12 years of asset. Comments/Proposals (i) Standardised construction period and IDC (ii) Benchmark capital cost notified by CERC (iii) International competitive bidding mandatory for all major plant packages R&M expenes need to be justified by useful life extension period. (i) Re-assessment of useful life after every tariff period/major capex (ii) Unrecovered depreciation due to dis-incentive allowed to be recovered (iii) Actual life may be much more than currently provided 25/35 years of useful life for generation/transmission assets. (i) Net fixed assets (NFA) as part of capital in ROCE approach. (ii) Alternatively, modify the existing GFA approach. Need to re-visit the 70:30 debt equity composition. i) With development of debt markets, switchover to RoCE approach. (ii) Methodology to benchmark cost of debt and equity for WACC. (i) Linking of ROE to market conditions and risk factors. (ii) Need for differential rate of return for hydro and transmission projects. (iii) Review treatment of Sec 80-IA benefit in grossing up tax rates. (iv) Reduction of RoE in respect of profits of regulated entities and risk premium. Normative interest rate linked to benchmark government bond yields. Review the base for receivables (2 months) computation, particularly inclusion of return on equity and depreciation. (i) Escalation factor linked to WPI and CPI index also factoring in expected efficiency gains (ii) Review efficacy of O&M cost as a percentage of capital expenditure for new hydro projects (iii) Treatment of other incomes-- interest on deposits, telecom revenues (for transmission assets) in calculating O&M costs. Impact

Renovation and Modernisation (R&M) expenses Depreciation

Net fixed assets approach

RoE of 30% (equity portion) on gross fixed assets creates internal resources for capacity replacement. Normative D/E ratio of 70:30, excess equity to be treated as loan. RoE approach has cost of debt as passthrough mooted earlier due to volatility in debt equity mix and interest rates. Post tax return on equity of 15.5% to be grossed up by applicable tax rate.

Debt Equity ratio Return on investment

Return on equity

Cost of debt Interest on working capital

Actual cost of debt is a pass-through. Working capital comprises normative inventories of fuel, maintenance spares, O&M cost and receivables. Normative O&M costs for generating stations and transmission assets with fixed escalation factors.

O&M cost

Source: CERC, Kotak Institutional Equities

KOTAK INSTITUTIONAL EQUITIES RESEARCH

India

Utilities

Exhibit 2: Fuel shortage also likely to be considered in setting normative PAF for coal stations Existing regulations and CERCs comments on operational parameters for tariff setting in the approach paper dated July 2013
Existing Coal based stations Normative PAF Normative PAF of 85% for all generating stations. 6-8.5% for coal based and 1-3% for gas based stations. Comments/Proposals Normative PAF different for (i) scenarios with fuel shortage and (ii) procurement of alternative fuel in case of shortage. (i) Includion of colony power and construction power in auxilliary consumption. (ii) Separate norms for auxiliary consumption in 300/330 MW units. Present level of SHR based on technological improvement to be factored in. None None Impact

Auxiliary energy consumption

Station heat rate (SHR) Secondary fuel oil (SFO) consumption Transit and handling losses Hydro stations Normative PAF Auxiliary consumption

Margin of 6.5%/5% over the SHR guaranteed by OEM for coal/gas stations. 1/1.25 ml/Kwh for coal/lignite based stations. Normative losses of 0.2%/0.8% for pithead/non-pithead stations Based on premise that water availability risk is to be shared equally by generator and 0.7-1.2% based on nature of excitation system

Need to review based on actual PAF data for past 4 years None

Source: CERC, Kotak Institutional Equities

Exhibit 3: RoE improves if coal requirements are met through imports Impact of various scenarios on NTPCs core RoE as per extant regulations
Scenario Linkage coal continues Linkage coal substituted by high cost imports Linkage coal substituted by low cost captive coal Linkage coal not substituted Probability Low High Medium Low PAF Impact PLF RoE

Source: CERC, Kotak Institutional Equities

KOTAK INSTITUTIONAL EQUITIES RESEARCH

Utilities

India

Exhibit 4: Tariff structure implemented in 2009 tightened operating parameters, though compensated through better incentives Key features of existing, draft and final CERC tariff regulations (2009-14) for a coal-based generating station

CERC regulations 2004-09 Return on equity Post-tax RoE (%) 14 Depreciation Accelerated depreciation (years) NA Accelerated depreciation (%) NA Balance depreciation (%) 3.2 Interest on working capital Coal inventory-pithead station (months) 1.5 SFO inventory (months) 2 Receivables (months) 2 Maintenance spares (% of O&M) 1.5% of capital cost O&M in working capital (months) 1 Normative O&M expenses First year (Rs mn/MW) 1.16 Escalation (%) 4 Cost of secondary fuel SFO consumption (ml/kwh) 2 Energy charge Normative auxiliary consumption (%) 9.0 Normative gross station heat rate for 500 MW unit (kcal/kwh) 2,450 Incentives Target availability factor (%) 80 Taxes on incentives Reimbursed Rs0.25/unit for generation above 80% PLF

CERC regulations draft 2009-14 14 15 4.67 2 1.5 2 1.5 20 0 1.25 4 1 8.5 2,400 85 Not allowed Increase in fixed charges proportionate to availability above 85%

CERC regulations final 2009-14 15.5 12 5.28 2 1.5 2 2 20 1 1.30 5.7 1 8.5 2,425 85 Not allowed Increase in fixed charges proportionate to availability above 85%

Incentive formula
Source: CERC, Kotak Institutional Equities

Exhibit 5: Sensitivity of PAF, is superior to PLF for core-RoE Sensitivity of core RoE to various ranges of PAF and PLF (%)
Sensitivity of ROE to actual PAF and PAF (%) 80 85 95 90 15.7 18.7 24.9 21.8 15.9 19.0 25.1 22.0 16.2 19.2 22.3 25.3 16.4 19.5 25.6 22.5 16.6 19.7 25.8 22.8 PLF 100 27.9 28.2 28.4 28.7 28.9

Exhibit 6: Higher blended price of coal helps improve RoE Sensitivity of RoE to coal prices and PLFs (%)
Sensitivity of ROE to coal prices and PLF Coal Price (Rs/ton) 1,760 1,980 2,420 2,640 2,200 21.2 21.5 22.1 22.4 21.8 21.4 21.7 22.4 22.7 22.0 21.6 21.9 22.3 22.6 23.0 21.8 22.2 22.9 23.2 22.5 22.0 22.4 23.1 23.5 22.8

22 75 80 85 90 95

22 75 80 85 90 95

PLF (%)

Source: Kotak Institutional Equities estimates

Source: Kotak Institutional Equities estimates

KOTAK INSTITUTIONAL EQUITIES RESEARCH

PLF (%)

India

Utilities

Exhibit 7: Summary valuation of utility companies under our coverage (as on July 2, 2013)
Rating SELL REDUCE ADD ADD ADD BUY BUY SELL BUY Mkt Cap. (US$ bn) 1.8 0.7 1.3 3.9 20.1 8.6 1.6 3.2 3.6 Price 2-Jul 44 340 47 19 146 111 357 68 87 Target price 35 320 50 26 175 140 810 75 104 Div Yield (%) 2013 1.5 4.3 4.0 2.8 2.6 3.3 1.5 2013 43.9 9.7 6.3 9.2 9.2 10.5 9.6 22.0 8.9 EV/EBITDA (X) 2014E 2015E 11.5 7.8 6.2 5.4 5.0 5.1 7.9 6.3 8.4 7.6 8.2 6.9 6.5 6.9 14.2 8.4 7.2 6.5 2016E 7.6 4.8 4.8 5.7 6.9 5.4 5.7 5.0 6.1 2013 (4.9) 10.2 7.1 10.2 11.0 12.1 5.0 20.3 21.6 P/E (X) 2014E 2015E (23.4) 9.7 8.9 8.9 6.7 8.0 9.2 8.0 10.5 10.0 10.3 8.7 5.3 4.7 24.9 14.3 15.1 13.7 2016E 9.2 8.5 9.0 7.4 9.6 6.5 3.2 7.7 11.4

Adani Power CESC JSW Energy NHPC NTPC Power Grid Reliance Infrastructure Reliance Power Tata Power

Adani Power CESC JSW Energy NHPC NTPC Power Grid Reliance Infrastructure Reliance Power Tata Power

2013 2.4 0.8 1.1 0.8 1.5 2.0 0.4 1.0 1.8

P/BV (X) 2014E 2015E 2.7 2.1 0.8 0.7 1.0 0.9 0.8 0.7 1.4 1.3 1.7 1.5 0.3 0.3 1.0 0.9 1.7 1.5

2016E 1.7 0.7 0.8 0.6 1.2 1.3 0.3 0.8 1.4

2013 (4.8) 6.7 7.7 5.5 8.6 6.8 6.5 3.2 5.1

ROCE (%) 2014E 2015E (0.9) 2.8 7.0 6.8 7.9 6.5 6.2 6.9 9.9 11.9 7.1 7.6 4.8 4.3 2.8 3.6 6.3 6.6

2016E 3.0 6.9 6.6 6.7 13.2 9.2 5.6 6.1 6.7

2013 (41.7) 6.5 17.5 8.1 12.6 15.9 11.0 4.9 8.2

ROE (%) 2014E 2015E (11.0) 24.7 7.0 6.7 15.7 11.4 8.5 9.2 14.7 17.2 16.5 17.1 11.2 9.4 4.6 6.6 11.4 11.5

2016E 20.7 6.6 9.7 8.9 18.3 19.7 8.8 11.2 12.5

Source: Bloomberg, Kotak Institutional Equities estimates

KOTAK INSTITUTIONAL EQUITIES RESEARCH

Disclosures
"I, Murtuza Arsiwalla, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report."

Kotak Institutional Equities Research coverage universe


Distribution of ratings/investment banking relationships 70% 60% 50% 40% 30% 23.1% 20% 10% 1.8% 0% BUY ADD REDUCE SELL 2.4% 1.2% 0.6% 24.3% 18.3% Percentage of companies within each category for which Kotak Institutional Equities and or its affiliates has provided investment banking services within the previous 12 months. * The above categories are defined as follows: Buy = We expect this stock to deliver more than 15% returns over the next 12 months; Add = We expect this stock to deliver 5-15% returns over the next 12 months; Reduce = We expect this stock to deliver -5-+5% returns over the next 12 months; Sell = We expect this stock to deliver less than 5% returns over the next 12 months. Our target prices are also on a 12-month horizon basis. These ratings are used illustratively to comply with applicable regulations. As of 31/03/2013 Kotak Institutional Equities Investment Research had investment ratings on 169 equity securities. Percentage of companies covered by Kotak Institutional Equities, within the specified category.

34.3%

Source: Kotak Institutional Equities

As of March 31, 2013

Ratings and other definitions/identifiers


Definitions of ratings
BUY. We expect this stock to deliver more than 15% returns over the next 12 months. ADD. We expect this stock to deliver 5-15% returns over the next 12 months. REDUCE. We expect this stock to deliver -5-+5% returns over the next 12 months. SELL. We expect this stock to deliver <-5% returns over the next 12 months. Our target prices are also on a 12-month horizon basis.

Other definitions
Coverage view. The coverage view represents each analysts overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

Other ratings/identifiers
NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances. CS = Coverage Suspended. Kotak Securities has suspended coverage of this company. NC = Not Covered. Kotak Securities does not cover this company. RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon. NA = Not Available or Not Applicable. The information is not available for display or is not applicable. NM = Not Meaningful. The information is not meaningful and is therefore excluded.

KOTAK INSTITUTIONAL EQUITIES RESEARCH

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