Coal Supplies and Price Pooling – At the Cost of Reforms - My Article in the Mining India magazine

In Indian coal sector, debate on the legal framework revolves around the efficacy of free markets. Historically, when coal sector was nationalized, the circumstances appeared to indicate that private enterprises were too profit focused to channelize their resources for safety and occupational health issues in the sector. The government ownership was viewed as a tool to improve safety records and provide appropriate work environment for the miners. Hence, the Coal Mines Nationalization Act, 1973 was promulgated and the sector came under the government ownership. Another reason cited for the nationalization of coal mines was to provide government funding for development of coal mines for meeting the energy needs of the nation, which was not seen as forthcoming from the private owners.

The circumstances have changed now. The private sector participation is being encouraged even though the degree of participation is still limited. The reason for this change in the policy outlook is that the gap in demand and supply seems to be rising by the day and the government-owned companies find themselves unable to match the expectations. Pricing policies seem distorted and make comparisons with the international markets irrelevant.

Rationing of coal output is done through linkages. The linkages have to be converted into fuel supply agreements with coal suppliers after the end-users meet the project milestones. These end-users have to provide bank guarantees to comfort the coal supplier about the progress of the end-use project while the supplier may commit only close to half of the contracted quantity and still not be liable to any commercial punitive payments. The calculation of the contracted quantity itself being done on obsolete normative principles does not seem to cause concerns when these extremes of rationing behaviour are assessed.

A relatively smaller proportion of the national coal output is sold through e-auction and the results of trades through e-auction mode further indicate that the concerns of supply shortages can force the consumers to resort to procurements irrespective of prices. It may appear that revulsions of free markets may not be as deep as those perpetuated by the government owned, controlled and regulated monopoly.

Inevitability of Coal Imports

Coal accounts for 53% of energy portfolio of India and feeds close to 70% of power generation. Coal is widely available in India and power generated from coal remains affordable. Coal based power generation technology has been reliable and robust. On environmental account, it may have challenges to face in times to come. However, suffice it to say that till 2032, all projections and estimates portray coal as the prime mover of Indian energy needs.

With about 54,000 MW capacity being added in the 11th Plan, the power sector recorded highest ever capacity addition in a plan period even though it missed the revised target of 62,000 MW for Plan period (2007-12). The capacity addition target for the 12the Five-Year Plan (2012-17) is about 79,000 MW, of which close to 66,000 MW capacity is to be coal based. The capacity addition target for the 12the Five-Year Plan (2017-21) is about 79,600 MW, of which close to 50,000 MW capacity is to be coal based.

The accompanying requirement coal therefore is substantial and domestic supplies seem failing to catch up with the demand. The demand and supply gap for coal has been rising in the past as well. The gap reached a level of close to 100 million tonnes for thermal coal in 2011-12, although the actual thermal coal imports were about 75 million tonnes. This was due to the reason that electricity distribution companies that have been in financial distress preferred to shed loads rather than buying high priced imported coal based power.

The total imported coal demand for the 2011-12 period was about 137 million tonnes. This seems to continue to rise in the next five years, to an alarming level of 434 million tonnes. The total size of the sea-borne global coal trade market is about 1 billion tonnes, which is estimated to rise at 3-4% per annum on an average, this when the demand from India is going to rise from about 137 million tonnes now to 434 million tonnes in the next 5 years. It would be stating the obvious that this will have a telling impact on coal prices. Coal prices have been volatile since 2003 and have seen peaks during 2008-09 and then 2010-11. Since the middle of 2011, prices stabilised in a lower band of USD 100 - 110 per tonne and then feel further towards the end of 2012 to levels of USD 80 – 90 per tonne. This may however be a relatively short-lived trend and when the demand from Indian power generation begins to pick again, prices will bounce back. 

Domestic and Imported Thermal Coal Price Pooling

Pooling as a concept assumes that assets of different risk and reward framework are grouped together to diversify risks and hence, have an impact on the asset prices. The other inherent assumption for pooling is that proposed assets to be pooled are all within one controlling entity. In case of price pooling for coal in India, while the first assumption is true to a large extent, the second is not. The imported coal basket of CIL seems small as of now when compared to the total imports in the country, which implies that those who agree to import through CIL may have advantage over those who have their own mechanisms of import such as their own FSAs or mines abroad. This would then tend to distort the market.

In some sense, therefore, the pooling of domestic and imported coal prices sounds a step back into the past from moving a step towards greater market orientation. There are large number of companies in power sector that are fundamentally different, some with integrated coal assets in India and abroad while some totally dependent on domestic supplies. Pooling may make better sense when all procurements are through one agency that takes care of domestic as well as imported supplies, and when the imported coal is rationed proportionately for all.

On diversification front as well, there are concerns. Those power plants that have thus far been getting assured supply of domestic coal at pit head or at reasonable distances from mines have assets that would now be clubbed with imported coal basket, which means their riskiness will certain jump and they would have to foot the addition price of imports. Compound this with the fact that price pooling proposal states that these plant may not get any physical imported coal. To them the proposal appears penal.

Those power plants who may get physical supplies of imported coal while the financially the impact of imports being on averaged over to all other power plants stand to gain. Due to accessibility concerns, it may seem logical to supply imported coal to coastal projects while those near the coalfields get domestic coal, while everyone bears the costs of importing. This may indicate the coastal projects alone to benefit from pooling.

The other significant side of the story is that in capacity addition for power generation, coal supplies have turned out to be the "bubble-maker" which seems bursting now. Several power projects saw sanction and investments based on Letters of Assurance (LOA) from Standing Linkage Committee on Long Term Coal Supplies, which did not take into account the burgeoning gap between such "assured" supplies and the actual physical availability of coal. This has led to projects advancing in implementation and getting commissioned when the coal supplies have not been able to come on line. Those power plants that went bullish on LOAs are likely ones to depend increasingly on imports and hence, the pooling mechanism may well be a partial bail out for them.

Coal as a commodity has large variances in energy content (GCV) and other parameters like moisture content, ash content, fixed carbon, volatile materials, sulphur content, Hardgrove Grindability Index and such others. These vary from source to source. Establishing pooling equivalents may itself be challenging. Further, allocation of shortages in supply from domestic sources and then pooling at coalfields, subsidiary or CIL levels will present complexities in the increasing order, which may make the pricing mechanism a statistical challenge.

Acceptance of the mechanism would depend on whether a power project is likely to get more physical imported coal that in effect it pays for. Those on the receiving end of the spectrum may not have an option to exit the system, which in a way is inconsistent with open market principles.

While the exact impact will depend upon the quantity of coal that CIL would import, prices thereof and mechanism of pooling (at coalfields level or subsidiary level or CIL level). But suffice it to say that cost of domestic coal for the existing consumers would go up. Estimates have been doing the rounds that at national level coal prices may go up by 5 to 10% (Rupees 100 to 200 per tonne) which may lead to an increase of 4 to 6 Paise per unit in the electricity tariffs. These, however, are only indicative.

However, on the investment side, this proposal may make companies reluctant to import on their own even when there could be strategic advantages, since imports through CIL with pooling of prices, one can get 'subsidized' imported coal.

Reforming the Sector

The coal mining sector desperately needs competition. The dichotomy is glaring that India has close to 285 billion tonnes of resource base and yet production cannot meet the demand and there is growing demand for imported coal. The Geological Survey of India estimate of resource base is gross number and does not account of depletion and mineability. Even while conservatism is applied to arrive at mineable resource of 50% of the gross resource, at the production rate of 500 million tonnes per annum, the reserve to production ratio, an indicator for life of mining, will be close to 150 years. And still India is expecting to import close to 434 million tonnes in 2016-17. 

Regulation of the coal markets and participants must complement competition. The role of coal regulator in the transition state from monopoly to free markets can never be overemphasized. It should facilitate removal of entry barriers, inflow of capital and investments, creation of commercially prudent trade arrangements and a check on exercise of market powers by the existing players. For the short run, creation of competition in coal sector is possible through seeding competitive spirit among the Coal India Limited subsidiaries. An effective way for the same may be simultaneous public listing of these subsidiaries in addition to CIL, the holding company that portrays a picture of monopoly.

Indian coal mining industry needs private capital for revitalizing itself. Unfortunately, the policy formulation in India still continues to focus on expenditures by the government and government-owned companies. Making exploration and prospecting activities financially attractive for the private sector may be better than allocating government funds for these activities, more so when the fiscal deficits of the governments have reached alarming levels. For this, the nation needs to formulate un-ambiguous mining development policy guaranteeing right to mine or sell an exploration asset. Indian private players have been scouting abroad for mineral assets, including prospecting and exploration properties. They have invested in South Asia, Africa and even Latin America while Indian mineral deposits have remained inaccessible for private investment.

Foreign investors in mining consider country risk lower when there is an explicit commitment and proven track record for supporting private sector investment. According to 2012 country ratings for mining investment published by Behre Dolbear, India fares relatively low on social issues, permitting delays, corruption and tax regimes, which have significant impact on foreign investments. The foreign investments in the sector have been, therefore, low.

For attracting private capital in the industry, the policies need to have precisely defined objectives, transparent regulatory processes, predictability and efficiency. Indian mining policies are vaguely worded and appear indicating desirable goals only. The regulatory frameworks are opaque and un-predictable, and do not have timeframe dimension. For promoting private sector investment, time-bound approval and objective processes that can have predictable outcomes would help.

Questions have been raised by several stakeholders on the efficacy of coal block allocation process, which is considered laden with scope for discretion and judgment. The Ministry of Coal has proposed competitive bidding process for coal block allocation. The competitive bidding process is likely to lend credibility to process of awarding mineral licenses. Initial payments or committed pay-outs to the government may also result in commercial incentive for mine owners to develop the mineral reserves sooner. However, it may increase the cost of production to an extent. The quantum of such monetary commitments may therefore need to be prudently fixed.    

Other characteristics of coal mining policies that may help attract private capital are simplicity of the procedures and stability of fiscal and regulatory regime. The procedures for clearances and approvals in the Indian context are labyrinthine and involve consents from scores of authorities. Single window clearance proposal has not got its due, and effectively, the door to private and foreign investors remains near-shut.

Conclusions

While India needs to focus on reforming the sector, unfortunately the steps are being taken to continue the rut and making imports appear less burdensome by price pooling with domestic supplies. While power generation sector has been increasingly market oriented, that sources equipment globally, supplies power on a competitive basis and that has options for merchant sales, the coal sector has been fully within the grips of government owned companies and prices are not competitive. This distorts the energy market and has led to rationing behaviour such as coal linkages, which by themselves have led to aggressive power generation investments, lending and now restructuring and financial woes. Coal price pooling will bot curb the excessiveness of risk taking in power generation sector and by spreading the risks to the entire coal portfolio in the country, the burdensome imported coal prices are likely to see reluctance on part of all the stake-holders, government more particularly, to dither on reforms.

Upon reforms, the expectation is that domestic prices may also see stability, if not a downward adjustment for the medium term. But more importantly, it will eliminate inevitability of coal imports which are expensive, cumbersome to handle, cause pressure on foreign exchange rates and lead to several other challenges.