Is captive coal mining failing?

While the success of their auctions is being debated, most coal blocks set aside for power generation are either languishing or producing at lower than their peak rated capacities

Reliance Power has terminated the Tilaiya 4000-Mw Ultra Mega Power Project (UMPP) agreement which was to develop associated coalmines and a thermal power project. These UMPPs were awarded with much fanfare and the discovered tariffs that were significantly lower than the then-prevailing electricity tariffs were projected as the success of the business model. However, with only two UMPPs implemented, one with captive mining and the other with imported coal, both having attempted to get compensatory tariffs in view of changes in the business environment, it is important to consider a basic flaw in the business strategy of bidding companies and captive mining as a policy.

To say that the business drivers of coal mining and power generation vary significantly, as do their risk profiles, would be to state the obvious. While coal mining is inherently risky, with high geological and technological uncertainties, these have only been coupled with challenges of land acquisition, rehabilitation and resettlement. Land-related risks are not unknown for power generation, but for coal mining they are more prominent, since one does not have the option of relocating coal resources. They can be mined only where they are found.

Coal miners have also to deal with uncertainties in quality and quantity due to geotechnical alignments and geological features. These are quite apart from the common risks of prices, demand, logistics and financing, among other things. Owing to these, only investors with higher risk appetites — of course, with higher expected returns as well — are likely to choose coal mining. But are these basic financial premises being met when we design a business model such as a UMPP?

File picture of Ratan Tata at the Tata Power-owned Mundra Ultra Mega Power Project, which has been hit by an increase in the price of imported coal

The competitive bidding process for UMPPs forced power companies to think of coal mines as merely coal sources with little or no returns, barely recovering costs. Even the UMPPs based on imported coal had the winning companies look at their Indonesian coal mines as cost centres. Tata Power signed a contract with Bumi Resources in Indonesia to supply coal nearly at cost, while they made an equity investment in this Jakarta Stock Exchange-listed company. When transfer of coal from Indonesian mines at cost, deeply discounted over market prices, became untenable in the light of an Indonesian law that was aimed at plugging revenue leakages from lower royalties and income taxes due to low pricing of coal, Indian power projects such as the Tata Power-owned Mundra UMPP became financially unviable too.

While the merits of the arguments seeking compensatory tariffs are the subject of legal interpretation, it would suffice to conclude that the business model of lower electricity tariffs based on cannibalising of coal mines abroad has been proven to be a flawed one.

The same pattern has been repeated in electricity tariff-based competitive bidding for integrated domestic coal mining and power generation projects, of which UMPPs were the epitome. The auction of coal blocks for regulated sectors, for independent power projects, through a reverse auction mechanism witnessed a bloodbath. The bidding criterion was the cost of coal that a bidder, a power generation company, was willing to bill for, and naturally, in the light of the objective of lower tariffs, the process was designed to favour lower-cost coal mining. Theoretically, this should have encouraged scientific mining targeted at high efficiencies.

For reasons of unconstrained exuberance and the rush to secure coal blocks, the auctions resulted in near-zero initial price offers for most coal blocks and the second stage of reverse bidding led to negative bids, which essentially meant that bidders were not only willing to waive the cost of coal mining from electricity bills but were willing to pay more to the state governments. This turned the risk-reward framework, taught in Finance 101 in most business schools, on its head. While the success of these auction processes is still being debated, the evidence so far points the other way. Most coal blocks for power generation are either languishing or producing at lower than their peak rated capacities. Even mines that were already producing coal have seen lethargic production growth.  

From these, we cannot conclude that backward integration into coal mining by a power generation company is a flawed corporate strategy, as there is merit in controlling raw material sources and their supply chains if they account for more than a third of the cost of generation. But we can certainly conclude that not viewing coal mining as a risky business with a risk-reward profile of its own, and viewing mines as cost centres, merely as pits from where feedstocks originate, is a blunder of corporate strategy. From an investor perspective, companies must do the right thing by containing losses as soon as they can, through termination of contracts.

Therefore, captive mining as a public policy needs re-examination. Is the process of natural resource allocation causing inconsistencies in financial and strategic decision-making processes? If we expect rational investors, would it then matter whether the resources are allocated to an independent miner or a captive one? Wouldn’t the government be better off by not being prescriptive in business integration, and instead giving market forces free play? Perhaps after a few more years of using these allocation processes their results will provide the needed evidence for course correction. 

The writer is an energy and resource sector consultant