Supreme Court’s Order on ‘Compensatory Tariff' Powers Accountability and Strengthens Competition

The judgement also puts a much-welcome end to the ‘bid low today, raise price later’ bidding strategy employed by power sector players.

In landmark judgement delivered on April 11, 2017, on the issue of ‘compensatory tariff’, the Supreme Court has put an end to arbitrary use of regulatory power, upheld the sanctity of contracts and significantly restricted the impact of power tariffs on consumers.

The judgement also holds implications for vital issues such as distribution utility finances, contract enforcement, regulatory governance, public policy, and consumer interest.

How did we get to this stage? Let’s take a look.

The beginning

The Electricity Act of 2003 de-licensed generation (except large hydro and nuclear), making it possible for anyone with the necessary statutory clearances to set up generating stations. Underlining the need for competition, Section 63 of the Act allows regulatory commissions to adopt a tariff for generation that has been discovered through a transparent bidding process conducted as per the guidelines issued by the central government. The guidelines emphasise a fair and transparent process for bidding and give the bidders an option to pass on the fuel price variation and other related risks by quoting various escalable and non-escalable charges transparently at the time of bidding. The bidding framework seemed like a promising start and more than 40 GW of capacity has been added under this regime.

However, soon enough there were indications of potential problems.

Early warnings

In 2010, the Central Electricity Regulatory Commission (CERC) published a study which pointed out that most of the tariffs discovered through bidding were more competitive than “cost-plus” tariffs determined for similar projects. In an analysis report published in 2011 Prayas (Energy Group) highlighted that the tariffs discovered through bidding were indeed lower than those determined on a cost-plus basis. However, the report also highlighted several governance concerns regarding bidding processes in several states including potential danger of post-bidding changes to tariffs. It noted that despite having the option of transparently passing on the fuel price variation related risks, many projects had won the contracts by willingly assuming such risks by quoting a fixed value for that part of the tariff.

Highlighting the potential fuel risks inherent in some of the fixed price bids, the report presciently questioned the feasibility and viability of these projects. Curiously, lenders and financers did not seem to be bothered by such bidding strategies although the general outlook regarding domestic coal sector was never too bright.

Too good to be true

As the projects approached commercial operation, many started complaining about viability issues on account of increased fuel costs. In 2012, some of these projects such as Tata Power’s Mundra UMPP and Adani Power’s Mundra project filed cases before the Central Electricity Regulatory Commission (CERC). They sought revision of the quoted tariff on grounds of increase in the price of Indonesian coal along with other issues such as shortfall in domestic coal supply and depreciation of the Indian rupee. Similar cases were also filed before the Maharashtra Commission and a few other state commissions.

The contracts – known as Power Purchase Agreements (PPA) –signed by these projects allowed revision of tariff only under two circumstances: change in law, whereby a legal action of a government body or a court imposes any cost (or results in benefit) and force majeure, which implies an unforeseen event that prevents or unavoidably delays the performance of obligations under the contract.

The companies approached the CERC claiming that the promulgation of the Indonesian regulation which aligned the Indonesia coal price with a market-determined benchmark price, should be treated as either a force majeure event or a change in law event and that they should be compensated for the hardship imposed on this account. Further, the projects also argued that if it is not possible to grant them relief under these provisions of the contract, then the CERC should use its broader regulatory powers under the Electricity Act, 2003, and provide relief to make the projects viable. This claim was supported on the grounds that such action of the CERC is necessary to protect not just the projects but also the investments (banks and lenders), which in turn would be in sectoral and consumer interest.

Regulatory overreach

While concluding that no relief is possible under their respective contracts, the CERC through its interim order in 2013, chose to use its overarching regulatory powers to grant the projects what it termed as “compensatory tariff”.

The commission noted its decision as follows:

“In our view, the parties should confer to find out a practicable solution and agree for compensation package to deal with the impact of subsequent event while maintaining the sanctity of the PPA and the tariff agreed therein. In other words, the compensation package agreed should be over and above the tariff agreed in the PPA and should be admissible for a limited period till the event which occasioned such compensation exist and should also be subject to periodic review by the parties to the PPA.”

This decision of the CERC fundamentally altered the risk allocation enshrined in the contract and imposed the entire burden of fuel price variation on to the consumers. Following this interim order, the CERC set-up a committee to evaluate the extent of compensation needed. Through its final order in 2014, the CERC allowed compensatory tariff to both Tata Power and Adani Power, which was to the tune of Rs. 2,300 crore and Rs. 3,600 crore respectively till March, 2016.

Following CERC’s footsteps, regulatory commissions in several states such as Maharashtra, Uttar Pradesh and Rajasthan adopted the same approach of revising competitively discovered tariffs by granting additional compensatory tariffs. Thus, even in the absence of any possibility of relief under the contract, the commissions were using their regulatory powers to grant compensatory tariff without any public consultation. According to press reports, the overall quantum of compensatory tariff granted by various commissions would have amounted to around Rs. 11,000 crore.

Lopsided nature of the Commission’s approach

In spite of repeated submissions, the CERC did not undertake any public process to grant such additional relief, though its decision would have affected electricity tariffs for consumers across five different states. While the commission took two years to decide the matter, it ruled out a public process on the grounds that “If the public process at this stage is adopted as sought by Prayas, it would result in further delay and spell doomsday for the petitioner.”

Since the commission was extending relief beyond the PPA terms and conditions, it was argued that an asset supported and sustained in this manner should ultimately belong to the consumers and hence should be returned to them at the end of the contract term at an appropriate transfer price. The commission rejected such suggestion stating that “As regards the suggestion of Prayas for return of the generation assets at the end of the useful life, we are of the view that this aspect will be governed as per the terms and conditions of the PPA and is beyond the scope of the present proceedings which is confined to compensating the petitioner for the hardship suffered by it on account of Indonesian Regulations.”

Such decisions highlight the lopsidedness of the commission’s approach in balancing interests of consumers. While granting the compensatory tariff, the CERC felt it important to go beyond the contract terms and conditions, but to provide similar considerations to consumers, it chose a strict and narrow interpretation of the law and contracts.

The ATE ruling

The compensatory tariff order of the CERC was challenged before the Appellate Tribunal for Electricity (ATE), which through its April, 2016 judgement, rejected the use of regulatory power to grant relief to the projects. It also ruled that changes in the domestic coal distribution policy and promulgation of the Indonesian regulation couldn’t be treated as change in law events under the PPA.

It however ruled that the change in the price of imported coal on account of the Indonesian regulation should be considered as a force majeure event and hence granted relief under the force majeure provisions of the PPA. After deciding that the projects can be granted relief under force majeure, the ATE however remanded the matters back to CERC without defining the exact quantum and extent of relief. The ATE also directed the CERC to decide the matters within three months of its April 2016 judgment. This meant that the entire responsibility of defining the scope and applicability of force majeure, as well as deciding the computation methodology fell on the CERC.

Meanwhile, appeals were filed against the ATE judgement before the Supreme Court by all parties – distribution companies, consumer representatives and also the generators. The Supreme Court did not stay the matters before the CERC, but it directed that “The order passed by the CERC shall be produced before this court on the next date of hearing. It is made clear that the order passed by the CERC shall not be given effect to, without getting permission from this court.”

The CERC, in December, 2016 granted relief to the projects under force majeure provisions, which was substantially lower compensatory tariff than what it had allowed in 2014.

The verdict and its implications

Given the series of developments mentioned above, the Supreme Court judgment is crucial in providing clarity on the following key issues:

• Composite scheme: The Adani Mundra project has different contracts with different state distribution companies. The tariff for the respective contracts had been approved by the concerned state commissions and hence the CERC’s jurisdiction in granting relief to Adani Mundra project by considering it to be a composite scheme was contested right from the beginning. In absence of a clear definition of composite scheme under the Electricity Act, 2003, the Supreme Court has cleared this ambiguity by ruling that “…“composite scheme” does not mean anything more than a scheme for generation and sale of electricity in more than one State.” This is a significant development and will have far reaching implications on what has been hitherto interpreted in terms of the number of projects and schemes that fall under the CERC’s jurisdiction.

• Use of regulatory powers: The Supreme Court has rejected the use of regulatory powers to alter tariffs or any provisions of the contract, so long as the bidding guidelines and the contract specifically deal with such issues. The judgement notes that “It is clear that in a situation where the guidelines issued by the Central Government under Section 63 cover the situation, the Central Commission is bound by those guidelines and must exercise its regulatory functions, albeit under Section 79(1)(b), only in accordance with those guidelines. As has been stated above, it is only in a situation where there are no guidelines framed at all or where the guidelines do not deal with a given situation that the Commission’s general regulatory powers under Section 79(1)(b) can then be used.” Since the PPA and bidding guidelines clearly define the circumstances and the manner in which the quoted tariff can be changed, the commission cannot use its regulatory powers to overrule such provisions.

This is very crucial as it upholds the sanctity of contracts while not taking away the regulatory power if it is needed in a situation where the contract or other legal and policy provisions are silent or inadequate. This clarity is very significant in improving the quality of regulatory decision-making, as it clearly defines the boundaries for the use of regulatory power. Given the broad and wide nature of regulatory power, the implications of this will be much beyond power purchase contracts and compensatory tariff matters.

• Impact of Indonesian Regulations: The Supreme Court has rejected the idea that the promulgation of the Indonesian regulation and the resultant price rise should be treated as a force majeure or a change in law event. With regard to its finding on applicability of force majeure, the court has said that: “This clause [Force Majeure Exclusions] makes it clear that changes in the cost of fuel, or the agreement becoming onerous to perform, are not treated as force majeure events under the PPA itself.” The judgement further notes that “It is clear that an unexpected rise in the price of coal will not absolve the generating companies from performing their part of the contract for the very good reason that when they submitted their bids, this was a risk they knowingly took.”

Further, the judgement notes that the term “law” cannot be construed to mean any law including both Indian and foreign laws, as “The meaning will have to remain the same whether coal is sourced wholly in India, partly in India and partly from outside, or wholly from outside. This being the case, the meaning of the expression “any law” in clause 13 cannot possibly be interpreted in the manner suggested by the respondents.”  Hence no tariff increase can be allowed on account of the change in Indonesian regulations. Therefore, no relief is applicable to projects / PPAs based on imported coal (such as Tata Mundra UMPP or Adani Mundra PPA with GUVNL based on imported coal).

• Impact of change in domestic coal policy: In October 2007, the government had notified what is called the New Coal Distribution Policy (NCDP), which spelt out the broad framework for future coal allocation. Subsequently, the government amended the NCDP in July 2013 to bring in consistency in the fuel supply agreements that were to be signed under the NCDP. While the 2007 NCDP was ambiguous regarding the extent of coal to be imported in case of any shortfall in domestic coal production, the 2013 amendment clearly laid out the percentage of domestic coal that would be supplied under the fuel supply agreements and hence the extent to which sourcing coal from other sources such as import or spot auctions may be needed. The amendment states as follows: “Taking into account the overall domestic availability and the likely actual requirements of these TPPs, it has been decided that FSAs will be signed for the domestic coal quantity of 65%, 65%, 67% and 75% of ACQ for the remaining four years of the 12th Plan for the power plants having normal coal linkages.”

The judgement holds that this amendment to the NCDP should be considered as a change in law event. It is to this limited extent that relief has been granted for period after July 2013 for projects that are impacted by such shortfall in the domestic coal supply. However, the exact quantum of the relief will have to be computed by the commission on a case to case basis after taking into account the given project’s fuel supply agreements, actual coal supply and cost of alternate coal arrangement.

The table below captures the decisions given by the various forums on the key issues concerning these matters.

Figure 1: Variation in Indonesian coal price from January 2012 to August 2016

Table 1: The twists and turns in rulings on compensatory tariff

In order to appreciate the potential impact of the relief granted by the Supreme Court one needs to consider various factors such as actual shortfall in domestic coal supply, extent of imports and the price of imports.

As far as domestic coal is concerned, the last year has witnessed an impressive increase in production from CIL and SCCL of about 43 MT and in fact CIL has been advised to reduce production to avoid excessive stockpiling. The benchmark price for Indonesian coal peaked around March 2012, but as Figure 1 shows it has been falling since then. So it seems that the worst of the Indonesian coal price increase was already past by July 2013. Given the fall in power sector’s demand for coal and increase in CIL’s production, one can also assume that the worst of domestic coal shortage is past. Thus, the impact is likely to be only for the period of one or two years from August 2013. Considering all these factors, our preliminary macro analysis shows that the total relief as awarded by the Supreme Court would only be around 20-25% of the relief granted by various regulatory commissions.

Some sections in the media have criticised the judgement saying that “mere” legal interpretation is a narrow way of looking at things and the Court should have been more concerned about project (un)viability. Some have questioned the role and need of quasi-judicial bodies like the regulatory commissions, if such decisions are going to be based on strict legal interpretations.

There are two issues with such arguments. One, they belie the fact that the judgement is not only legally sound, but also forward looking for a sector plagued with NPAs, as it discourages aggressive bidding by holding bidders and their lenders accountable for the risks that were willingly assumed to win the contracts. In fact from a competition point of view, it is a landmark judgement as it not only upholds sanctity of contracts, but also enforces the rule of law and creates a level-playing field. Two, it brings out the dichotomy of the utilities in calling for the use of regulatory powers to balance individual party’s interest against the broader sector interest only when it suits them. Mumbai’s parallel distribution license is a good case in point. In 2003 the Maharashtra Commission had taken a “balanced” view by ruling that though Tata Power Company has a parallel license to distribute electricity in Mumbai, it should be allowed to function as a parallel licensee only after few other preconditions are fulfilled. At that time, Tata Power Company challenged the said interpretation of the commission in all forums up to the Supreme Court, till it got a strictly legal interpretation on the issue that allowed Tata Power to undertake retail supply in Mumbai.

In general, the commissions should indeed take decisions that are in the larger sector’s interest, which may be broader than specific companies’ interests or issues of viability but beyond the strict and narrow interpretation of law. However, such decisions need to be guided by certain principles that would define the circumstances under which such actions are called for and the extent to which the commissions can deviate. In this regard, the Supreme Court’s judgement is a big step forward. Coming from the apex court, such clarity has the force of law and hence it will not be limited to power purchase contracts and tariff issues, but will apply to broader sector issues while also setting a good precedence for other sectors to follow. Secondly, the judgement has undoubtedly strengthened competition by enforcing the rule of law and holding bidders and lenders accountable for the risks that had been willingly assumed to win the contracts. Such clear and accountable mechanisms will not only discourage aggressive bidding based on risky fuel arrangements, but will also lead to more realistic tariff discovery for future projects, which would also provide more realistic price signals for the sector at large. To conclude, the judgement indeed puts an end to the ‘bid low today, raise price later’ strategy of bidding.

Ashwini Chitnis and Shantanu Dixit work for the Prayas (Energy Group), Pune. The Prayas (Energy Group) is one of the authorised consumer representatives before the Central Electricity Regulatory Commission (CERC) and has been involved in the entire process pertaining to the grant of compensatory tariff by CERC and MERC.