ROA for Backward Integration into Coal Mining by Power Generation Project - My article in the Mining India magazine

Indian power generation sector has been facing growing demands that the sector has not been able to keep pace with. The shortages at peak loads have breached the range of 13%. This scenario has been forecast to continue as the capacity additions in power generation have fallen short of planned capacities. There are several reasons for the slow growth in capacity additions, including issues of land acquisition, rehabilitation and resettlement, financing, environmental and forest clearances, tight regulatory control on tariffs and fuel supply concerns. Of these, fuel supply concerns have been predominant. Indian power generation sector depends largely on coal with nearly 55% of the power generated from coal sources. This contribution from coal sources have been projected to continue for a foreseeable future due to availability, accessibility and affordability of coal. However, the growth in demand for coal has outpaced supplies. The shortfall in demand and supply of coal for power generation has reached nearly 50 million tonnes in 2010 and is expected to reach nearly 100 million tonnes by 2012. This has forced power generation project developers and investors to consider backward integration into coal mining.

Application of real options

Over the last 5 years of race for acquiring coal resources in India and abroad, power generation companies have been evaluating blocks to explore and produce coal. Where net-present-value (NPV) analysis suggests that the economics are positive, the companies enter into transactions to acquire the asset. Where the blocks prove uneconomic —as many do, usually because development costs are too high in relation to expected savings —acquisition is shelved.

All this, however, assumes the value of coal block what the blocks would be worth if the company starts developing them immediately. Real option technique on the other hand proposes evaluation of an opportunity as an option to develop if, at some point in the future, tariffs in the power generation sector make the backward integration economically feasible; or recoverable reserves increase through the use of new drilling and production technologies; or the price of coal from the market rise to an extent that can offset development cost; or a combination of these and other parameters.

In other words, the managers should apply the notion of options, as conceived in financial markets, to their own business situation. The question is the application of real options technique in the coal mining sector to assess a backward integration opportunity for power generation companies in India.

The approach can impact the way projects are evaluated

An increasing number of academics and corporate practitioners have been dissatisfied with the existing methods of resource allocation. Studies of corporate practices by Donaldson and Lorsch (1983), among others, reveal a continuing discrepancy between traditional finance theory and corporate reality, suggesting that managers have often been willing to overrule traditional investment criteria in order to accommodate operating flexibility and other strategic considerations they consider just as valuable as direct cash flows. It is now widely recognized, for example, that traditional discounted-cash-flow (DCF) approaches to the appraisal of capital-investment projects, such as the standard net-present-value (NPV) rule, cannot properly capture management's flexibility to adapt and revise later decisions in response to unexpected market developments. Traditional DCF approaches make implicit assumptions concerning an "expected scenario" of cash flows and presume management's passive commitment to a certain static "operating strategy" (e.g., to initiate a capital project immediately, and to operate it continuously at base scale until the end of its pre-specified expected useful life).

However, in the actual marketplace, which is characterized by change, uncertainty and competitive interactions, the realization of cash flows will probably differ from what management expected at the outset. As new information arrives and uncertainty about market conditions and future cash flows is gradually resolved, management may have valuable flexibility to alter its initial operating strategy in order to capitalize on favorable future opportunities or to react so as to mitigate losses. For example, management may be able to defer, expand, contract, abandon, or otherwise alter a project at various stages of its useful operating life.

This managerial operating flexibility is likened to financial options. A call option on an asset (with current value V) gives the right, with no obligation, to acquire the underlying asset by paying a pre-specified price (the exercise price, I) on or before a given maturity. Similarly, a put option gives the right to sell (or exchange) the underlying asset and receive the exercise price. The asymmetry deriving from having the right but not the obligation to exercise the option lies at the heart of the option's value.

An options approach to capital budgeting has the potential to conceptualize and quantify the value of options from active management and strategic interactions. This value is typically manifest as a collection of "real options" embedded in capital-investment opportunities, having as underlying asset the gross project value of discounted expected operating cash inflows. Many of these real options (e.g., to defer, contract, shut down, or abandon a capital investment) occur naturally; others may be planned and built in at some extra cost from the outset (e.g., to expand capacity or build growth options, to default when investment is staged sequentially, or to switch between alternative inputs or outputs).

Constraints in application of real options

The mining industry is one of the highest risk sectors in business. There are not methods to predict future cash flows of a mining project with any degree of accuracy during the 30 to 50 years of life time of this mine, including any metal prices, and prices of major inputs can be predicted with confidence. These may make application of traditional as well as real options seemingly difficult. However, real options obviously give better insights when an asset can be utilized at different points of time, depending upon emerging market conditions. Even then, the mining industry still does not use or adopt real options as a standard analysis when evaluating a (greenfield/brownfield) mine project.

Some of the main reasons are that it seems too complex and the lack of tools to run real options analysis and thereby be able to compare the results with more standard and well established methods.

One of the concerns with regard to the application of real options is that an attempt is made to take into account risk factors in valuation inputs by applying adjustment factors (typically probabilities). This process introduces additional risk to the valuation process, which remains un-quantified in the real options realm. The process of applying probabilistic risk factors on fundamental inputs also makes the process discretionary. Instead of dealing with "solid" expectations, one deals with adjusted inputs, and for non-specialists there is a general sense of reduced transparency and auditability of fundamental inputs.

The key to adopting techniques like real options lies in the organization having the right strategy and options skills, with the mental agility to view a project in that way are lacking within the finance structures of the organization. Even global multinational companies continually struggle with how to use what are essentially high caliber but generalist skills in strategy and problem-solving. Clearly, someone using real options requires a high level of skills in mathematics, resource modeling, and mine optimization. To find human resources with all these skills is difficult.

The real options modelers of the mining industry need to have a strong mathematical and financial background. When the traditional approaches are looked at for their results it seems crude assumptions have been used to solve cases of evaluation (for example, most analysis may not consider the variable grade distribution available to a mine). It seems that the real options approach using simulation is able to have much more realistic assumptions. One of the key requirements for the simulation approach is automated optimizing scheduling tools which are in very short supply in the industry.

Case for Application

Indonesia has emerged as the largest source of thermal coal for India. Power generation companies looking to secure coal supplies and to control prices are actively pursuing acquisition opportunities in Indonesia. While, due to regulatory changes made in the last couple of years and uncertainty in some of the implementing regulations, the pace of investments is likely to slow but the interests in Indonesian coal is unlikely to be abated. This is certainly due to proximity to Indian shores and potential of inland transportation through waterways. With the Indian electricity consumers determining the affordability of coal from import sources, these advantages work in favor of Indonesian coal.

If the price of coal is considered to be one single key determinant of value and for investment decision making, then using traditional evaluation mechanisms can lead to erroneous results as it would depend upon the time at which the decision is being made.

Considering the price movements for the past as depicted in the chart below, where prices are in US Dollars per tonne FOB at ports of Australia and South Africa.

Even if it is assumed that there is relatively higher degree of accuracy in price predictions or forecast, using NPV or IRR method in May 2008 for assessment of a coal mine in Indonesia for power project in India would indicate a negative decision. This would change if the same asset were to be analyzed in May 2009. In the absence of real options technique the power generation company would let the investment opportunity pass by since the NPV at these points of time are discreet.

But when real options technique is utilized, the decision of investment includes new parameters, which may have to evaluate what if the project is started with a time lag of if the investment in equipment and machinery and hence, production is delayed. These may be captured through the following decision possibilities:                       

Traditional methods -

May 2008 -NPV is likely negative, do not invest. Resultant – less expensive investment opportunity foregone

May 2009 - NPV is likely positive, do invest. Resultant – more expensive investment opportunity taken up

Real Options methods:

May 2008 -Possibility of upturn and unlocking when prices pick in a year. Resultant – less expensive investment opportunity taken

May 2009 - Similar to traditional methods.

From the view of power generation companies in India that have been looking for coal assets in Indonesia and other countries, the strategic intent is to secure supplies for the project life. This strategic decision using a traditional approach can cause havoc and lost opportunities for fuel securities.

Conclusion

Power generation companies in India that have been on the prowl to acquire coal assets abroad must consider the real option evaluation for assessment of the targets since their objective are long term and they have the option to decide the course of coal mine operations, which in itself has value attached.

The following framework (Source: Real Options – Managerial Flexibility and Strategy Resource Allocation by Lenos Trigeorgis) summarizes the sources of value in an asset, which are likely ignored by the traditional approaches of evaluation.

Category Description

Option to defer Management holds a lease on (or an option to buy) valuable land or resources. It can wait x years to see if output prices justify constructing a building or a plant or developing a field.

Time-to-build option (staged investment) Staging investment as a series of outlays creates the option to abandon the enterprise in midstream if new information is unfavorable. Each stage can be viewed as an option on the value of subsequent stages and valued as a compound option.

Option to alter operating scale (e.g. to expand; to contract; to shut down and restart) If market conditions are more favorable than expected, the firm can expand the scale of production or accelerate resource utilization. Conversely, if conditions are less favorable than expected, it can reduce the scale of operations. In extreme cases, production may be halted and restarted.

Multiple interacting options Real-life projects often involve a collection of various options. Upward-potential-enhancing and downward-protection options are present in combination. Their combined value may differ from the sum of their separate values; i.e., they interact. They may also interact with financial flexibility options.

It can only be expected that with computing tools available with high computational speeds that can make even simulation exercises feasible in no time, the application of real options for evaluation of coal mines by the strategically keen power generations companies will begin to be in vogue soon.