Authored by Abhishek Tripathi and Anura Gupta

Private sector participation in power generation has been at the core of power security in the last two decades, with independent power producers (IPP) currently owning 46% of the total installed generation capacity in India. Unfortunately, the sector that attracted FDI in excess of US$14 billion in the last two decades, faces upheavals, many of which are not of its own making. The recent action of the Andhra Pradesh government (APG) in threatening to terminate power purchase agreements of private developers unless tariffs are reduced is the latest problem to befall the sector. This has sent shock waves not only through IPP, but also those considering investment in the infrastructure sector in India in general.

The legality of the proposed action is doubtful. The contracts in question were awarded through competitive bidding, the bids reflected market realities at the time, and projects were funded on the basis of the power purchase agreements (PPA) executed after the bidding process. It is unrealistic to expect the bidders to reduce tariffs to the levels that may be more appealing at a later stage, and any coercion of the developers is unconscionable. Unilateral reduction in tariffs will be contrary to the contractual terms, and termination of the contracts if tariffs are not reduced will be in violation of the contracts.

Renegotiating contracts at this stage affects not only the developers, but also the investors, banks and financial institutions that funded projects on the basis of the executed PPA. In most cases developers may even need the consent of their investors and lenders to renegotiate the contracts. Reductions in tariffs will most certainly affect the financial viability of projects, which are grappling with delays in payments from distribution companies (discoms). This will put further pressure on projects, some of which may have to undergo debt restructuring or insolvency resolution processes unless the central government and the Reserve Bank of India intervene.

Unilateral reduction in tariff or termination of PPA by the government, if contested, should result in significant damages being awarded to developers for breach of contract. Foreign investors may invoke bilateral investment protection agreements. In domestic proceedings, it may be that arbitrators and the courts award compensation based on loss of future earnings during the contract term due to a reduction in tariffs. Such damages are rare, particularly in infrastructure and construction contracts. That perhaps encourages governments and their agencies to violate contracts. The consequences of such acts are more beneficial than adhering to the contracts. Delays in contract enforcement, and reducing cash flows during the following period often force contractors and developers to yield to unfair demands by the authorities and agree to reduced payments. That may well happen with the developers dealing with the APG. However, it does not augur well for the public private partnership (PPP) ecosystem, particularly attracting investors, and institutional and multilateral credit.

The reasons for the APG taking this action are hard to defend. Mounting discom debt is a crisis that has been many years in the making. Several factors are responsible for this, but high solar and wind tariffs are hardly a significant one. Solar tariffs have seen some fluctuations, with rapid drops initially, but rising later to more sustainable levels. In fact, many financial analysts doubted that low tariffs offered during bidding were sustainable, as they left the developers with very little room for margin. Currency volatility, credit availability, fluctuating borrowing costs, and other factors affected tariffs in each round of bidding. Developers accepted those risks and developed a business model that was distinct from the cost-plus business model for tariffs.

For the government, then to choose the lowest tariff as the benchmark, particularly in view of its tardy payment record, demonstrated its complete ignorance of market realities. Poor payment records by themselves may justify an increased tariff for a bidder. Early risk takers in solar power generation should be worried, as many other governments following the lead of the APG may seek reduction in solar tariffs, which are several times higher than the tariffs that the APG seeks to reduce. Such actions are sufficient to worry independent developers and investors.

Certainty of laws and the sanctity of contracts hold the key to India’s growth. Weak contract enforcement appears to be the single largest roadblock to India’s rise in the ease of doing business rankings. All government efforts to improve the ranking will be futile if governments themselves are seen as disregarding contracts. The mandarins in Delhi should be heeding the warning signs.