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Wind Energy Growth Outlook and Credit Issues

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Typography

Over the last five years, wind sector has whipped up 17 per cent annualised growth in installed capacities owing to favourable policies. CRISIL Ratings believes the party will continue a good five more years: India’s wind energy sector could see investments of Rs.650 billion in three years enabling capacity additions to surpass the Twelfth Plan goal. Some of the factors driving investments in the sector are:

>> Availability of generation-based incen- tives (GBI) of 50 paise/kWh subject to a maximum of Rs.1 crore per mw over 10 years

>> Attractive internal rate of return (IRR)  in the range of 16.5-18.5% (including 150 bps from GBI) because of promising state government policies, including a favour- able feed-in tariff

>> Wind power close to attaining grid par- ity, and a flattening of the technology curve which stabilises wind- turbine cost

Further, in the Union Budget for fiscal 2015, the NDA government had reintroduced accelerated depreciation (AD) benefits for the sector after it was discontinued in fis- cal 2013. CRISIL believes this will revive capacity additions by AD beneficiaries after a gap of two years. We believe the reintro- duction of AD and the continuation of GBI till 2017 will mean wind-power capacity additions will surpass the Twelfth Five Year Plan and grow by 10 gw between 2015 and 2017. That will translate into investments of Rs.650 billion of which Rs.450 billion will be in the form of debt.

Capacity additions have been policyelastic

Investments in the wind power sector are typically sensitive to changes in policy.

Between 2003 and 2010, India added more than 10 gw of wind power capacities, and nearly 70% of this was to leverage benefits under AD (Chart 1 & Chart 2). Under this scheme, developers could avail of tax benefits by depreciating 80% of their assets in the first year itself. As a result, captive power producers, large corporates (including  public  sector  undertakings)  and even retail investors set up projects.

GBI was introduced in 2010, which opened up the wind-power sector to a new investor – independent power producers (IPP). The purpose was to incentivise generation instead of just setting up capacities to avail tax benefits.

Driven by both AD and GBI, the wind capac- ity additions in India were the highest in fiscal 2012 at around 3,200mw. However, in fiscal 2013, the government withdrew the AD benefit 4 given the maturity of the wind sector (reasonable scale achieved by wind capacities). It was also withdrawn because, while players were set- ting  up  capacities  to avail tax benefits, these capacities were not being utilised optimally. GBI also expired at the end of fiscal 2012. As a result, capacity additions nearly halved to 1,700 mw in fis- cal 2013.

But with the restoration of GBI in fiscal 2014, capacity additions picked up again to 2,100 mw, despite the AD benefit not being available. Not surprisingly, most of the capacities were added by IPPs availing of GBI benefits. CRISIL believes that the reintroduction of AD, coupled with projects by IPPs (to avail of GBI benefits), will  result in wind capacity additions of more than 10 gw between 2015 and 2017.

IPPs will power the sector in the next five years

Of late, there has been a surge in interest among IPPs, which increases the prob- ability of achieving India’s Twelfth Plan wind-energy installation target. Prominent IPPs with a sizeable portfolio of assets are expected to contribute more than 75 per cent of the new installations. Because of this, the ownership pattern of wind farms  in India is changing, shifting away from ‘depreciation seekers/tax savers’ to serious, long-term IPPs. This has also meant the size and scale of single-location wind farms are increasing. CRISIL sees an emerging trend of first-generation entrepreneurs backed by private-equity investors entering the fray. While IPPs owned by established groups with a presence in power or other  sec- tors will contribute to half of incremental capacities, first-generation entrepreneurs with funding support from private equity players are likely to set up the balance. This will mean a capital requirement of Rs 500 billion and debt of Rs 350 billion.

What’s luring entrepreneurs?

A host of factors beginning with government policy. Today, instead of accelerated depreciation, wind-power  producers  get  a generation-based incentive (GBI) of 50 paise/kWh subject to a maximum of Rs.1 crore per mw over a period of 10 years – a move that has encouraged IPP participation and also increased the economic size of projects enhancing scalability of renew- able power through this source. While GBI makes wind sector attractive to large IPPs, CRISIL believes GBI is also a credit positive as it increases project IRR by 150 bps, thus strengthening the project risk profile. From a debt-servicing point of view, GBI benefits also improve project DSCR by approximately 0.1.

The adoption of feed-in tariffs by the Central Electricity Regulatory Commission (CERC) has made the sector even more attractive for investors. The zone-based generic guidelines laid out by the CERC offer a 20 per cent return on equity (RoE) under a controlled plant load factor sce- nario. Even though states are free to adopt their own feed-in tariffs, they are broadly guided by the principles of the CERC guidelines for determination of tariff from renewable sources. As a result, wind energy projects now offer an internal rate of return (IRR) of 16.5% to 18.5% (including 150 basis points from generation-based incentive).

Other positives include sops in grid code (schedule can change until half an hour before supply, etc) and Section 80-IA ben- efits (tax holiday for 10 years). Yet, adher- ence to renewable purchase obligations has not been ensured thus far because of the lack of a penal and/or incentive mecha- nism. And weak financials of discoms will keep them from meeting commitments anytime soon. It is for these reasons that renewable energy certificates (REC) haven’t found many takers. Most recently, the  State Electricity Regulatory Commission of Uttarakhand had imposed a penalty on its discom for missing its renewable power obligation (RPO) target. CRISIL believes stricter enforceability of RPO will offer tailwind to the certificates market and demand.

Flattening technology curve has stabilised wind  turbine  costs.  Today,  capital  cost   is in the Rs 6-6.5 crore per mw range. Simultaneously, the cost of generation from  conventional  sources  such  as coal-and gas-based plants has inched up due to increasing fuel cost. Wind power is there- fore moving closer to  grid  parity  (Chart 3), while other  renewable  sources  such  as solar thermal and photovoltaic require bundling with lower-cost conventional power to make them affordable – and have scalability constraints, too. This has made wind power attractive to both discoms and open-access consumers, thereby opening the avenue for captive third-party model.

Business models in wind energy

The introduction of feed-in or preferential tariffs has added an element of certainty to tariff structures over the life of wind energy assets, while providing reasonably attractive returns adjusted for the wind resource of each state. The preferential tariff model has drawn maximum investments -- nearly 70 per cent of installed capacity -- and will remain the favoured option of wind-based IPPs.

The REC model was introduced by the gov- ernment to help states not well endowed with renewable resources to meet their RPO targets. However, after the initial euphoria where superior returns were made by trad- ing renewable energy certificates, interest completely vanished leaving a heap of unsold inventory.

The model that has now caught the developers’ fancy is the captive third-party consumer model. Sales here are done to third-party consumers who pick up a nominal stake in wind farms, thereby averting open-access charges. The tariffs are linked to commercial or industrial rates paid by consumers to discoms, and are usually higher than feed-in tariffs of states, thereby offering  higher,  PLF-risk-adjusted  returns (Chart 4).

Re-introduction of AD to revive the growth from captive power producers and tax beneficiaries

CRISIL believes the reintroduction of AD will  spawn  sharp  growth  in  the near-to-medium term as beneficiaries  queue  up to take advantage. Captive power producers and pure play tax beneficiaries  benefit from AD as it helps them avail tax benefits through 80% depreciation of the wind assets in the first year itself. This helps in improving cash flows from their existing business operations. As these tax benefits are front ended (available in the first year itself), the effective   IRR   for  the wind projects increases by around 500 bps (on factoring the gains from tax savings).

Who are the key consumers, and what will drive future demand for AD?

>> Captive power producers: Companies from capital-intensive industries such as mining, cement and textiles will be interested in setting up wind projects for two reasons: tax deduction available against existing businesses; and captive power, which reduces their costs.

>> Pure-play tax beneficiaries: Real estate, financial institutions, and individuals were setting up wind projects purely to leverage tax benefits. But as the AD sop ended, new projects nearly dried up 2013 and 2014, with some of them even gravitating towards solar energy. Now the restoration of the AD benefit is expect- ed to renew interests in wind power.

>> Public sector undertakings: While PSUs are not big on wind capacities, they could join the fray soon even as the central government pushes renewable energy. Another catalyst is the corporate social responsibility (CSR) mandate where a portion of corporate profits has to be spent on socially beneficial activities. As investments in wind power classify as CSR spending (besides, the tax benefits), PSUs are also expected to join the fray.

Key credit drivers for wind players

Wind projects are comparatively less risky

As such, risk-adjusted returns on wind power projects – which typically have shorter gestation periods and are modular in  nature  –  are  higher   than those on thermal projects. While post-commissioning risks in conventional power projects (fuel shortage, higher operating risk, wind variability, regulatory and counterparty risk, to name some) are com- parable with the risk of wind variability, the pre-commis- sioning risks (land acquisition, clearances, gestation period, financial closure etc) are way lower for wind farms.

Wind variability and weak credit quality of counter-parties the primary risks

At the time of commissioning and in the early years of  operation,  wind  variabil-  ity risk manifests in the form of estima-  tion error and/or sharp deviation in actual energy output compared  with  estimates in wind velocity studies. The error could arise due to technical shortcomings such as measuring wind velocity at an  incorrect mast height, sample bias because data used to estimate average energy output is of relatively small periods, faulty estimation of power curve of a wind turbine, etc.

Thus, the inherent risk of wind variability year-on-year is characteristic of the wind energy sector and could impact cash flows and credit qualities of wind-based IPPs. Among the key assumptions in modelling debt service coverage ratio (DSCR) for proj- ects, none has more bearing on viability than PLF (Chart 5). Ceteris paribus, sensitiv- ity of DSCR is the highest to changing PLF.

Thus, to factor estimation error and wind variability risk, CRISIL uses the P90 level of annual energy output when calculating DSCRs. Only in exceptional cases where the variance between P90 and P75 is not too wide is the latter used. Given the practice of lenders to adopt P50 and P75, CRISIL’s assumptions may look conservative.  But in international experience the actual per- formance of wind farms has mostly been underwhelming and has consequently led to tightening of assumption parameters. For CRISIL’s own portfolio, the performance of projects monitored over the last four years has more often than not ranged between P75 and P90 (Chart 6).

Seasonality in wind flow and therefore intra-year variability in energy output can be planned for in a  much  better  man-  ner by crafting debt repayment to match cash flows and building additional liquidity through mechanisms such as debt service reserve accounts, etc.

Counter-party risk profile

The dichotomy of the wind power sector  in India is that states with the richest wind resource have the weakest financial profile, such as Tamil  Nadu and Rajasthan (Chart 7). CRISIL uses its framework of classifying financial risk profile of states based on three parameters -- AT&C losses, revenue gap per unit, and gross indebtedness 5.

Credits : CRISIL