It’s ironic. The outlook on the Indian power sector has never looked so dim. Fuel shortages, mounting losses and waning investor enthusiasm have ensured the sector’s future looks very bleak. But here’s a company that lends exclusively to power companies — and it’s doing very well. What’s more, it’s a public sector enterprise. Ask Power Finance Corporation (PFC) chairman Satnam Singh how’s business and he beams. Profits are up and loan asset creation is accelerating. “Business is very good,” Singh says, adding that PFC is one of the fastest-growing PSUs. That’s all the more remarkable considering that over 60% of PFC’s dealings is with cash-strapped state power utilities that don’t even meet their costs. 

PFC’s current growth story can be accounted for partially by the high-capacity additions in the power sector during the 11th Five-Year Plan (53,922 MW was added between 2007 and 2011, although that is still below target). But what’s worked in its favour, over the years, is the way its loan agreements are structured and some exemptions given by the government. It’s an advantage the navratna has built on for the last 25 years, but can it continue banking on that even in the future?

The real story

PFC was created in the 1980s with one mandate — offer cheap, long-term loans to the power sector. But with a caveat: the funds would be sanctioned only if the state government agreed to get its act together and turn around the electricity board. “People called it a mini-World Bank because of this condition,” recalls TN Thakur, former director finance of PFC. 

But PFC couldn’t have got off to a worse start. A few years after its launch, the company’s exposure to some bonds that had been part of Harshad Mehta’s stockmarket scam left it sick. In 1995, an action plan to revive PFC was put in place; what also remained unchanged was the reform agenda. By the mid-1990s, “States were reform oriented,” recalls Thakur. “Many steps were taken like unbundling of state electricity boards, setting up of regulatory commissions.”

That was also the time when international banks started financing private power plants in India. The concept of project finance was becoming part of the parlance. The trouble was, state power utilities, which were already broke, needed to borrow not only for their projects but also for working capital requirements. And no bank was ready to take large exposures to state electricity boards. Banks and financial institutions however, were lending to independent power producers (IIPs) that were selling electricity to these cash-strapped utilities. Therefore, lending to IIPs could happen only with watertight contracts that covered all risks. 

On their part, states, which had lined up several MoUs with private promoters, didn’t have the cash flow to give surety to all promoters that they would be paid their due amount and that too on time. The result: barely a handful of private projects that were signed took off.

What was PFC doing while all this was going on? While it, too, jumped on the private power lending bandwagon, the PSU had already started implementing its own version of watertight agreements with states. That’s an advantage PFC is enjoying even now.

First among equals

Essentially, PFC’s loan agreements with state utilities had two riders that ensured its payment security. First, it asked the state government for either a guarantee covering the entire loan or a first charge on the state utility’s assets of the state utilities to which it lends. Over the years, though, PFC did away with the state guarantee. Instead it now insists on two conditions: a first charge on the assets of all state utilities to which it lends, a first charge on the revenues of the utility.

And the latter involves a tripartite agreement between the utility, PFC and the main banker of the utility under which the utility agrees that if it defaults on the loan, the bank (which operates the utility’s accounts) will set aside the utility’s revenues in a separate escrow account and PFC can use those funds to get back the maximum repayment due to it. “The amount committed under this arrangement is the maximum due to us for whatever we have lent to the utility until then,” adds Singh. 

A banker adds, “This two-layer security arrangement is a sweetheart deal for PFC, and it explains why states never want to default on its loans.” Not surprisingly, not only do state utilities keep borrowing from PFC, they also repay their debt without default. But Singh clarifies that PFC’s growth is not based on invoking the escrow on a regular basis. He says PFC has a recovery rate of over 99% — the escrow guarantee has been invoked twice in the last two decades. To date, PFC has ceded its first charge on revenues for only two states — Tamil Nadu and Maharashtra — although it still retains the escrow guarantee on loans it gives to these states.

Advantage PFC

It’s not only the agreements that PFC makes with states that give it an edge, there’s also the fact that the PSU has additional leeway, thanks to government mandates.

For starters, PFC isn’t as bound by the Reserve Bank of India’s (RBI) prudential norms of group and special purpose vehicle (SPV) exposure. Banks, financial institutions and other non-banking financial companies (NBFCs) are subject to the norms for both private sector lending as well as for state and central projects. In contrast, the company (also an NBFC) is exempt from the norms when it comes to state and central projects, although it has to follow them when lending to private projects. 

Under the prudential norms, a lender’s exposure cannot be over 40% of their net worth while lending to companies under one group (like, say, GMR group, which has interests in roads, power and airports); for a group’s SPV (say, GMR Tollway Project), the lending is capped at 25% of the institution’s net worth. PFC, in contrast, can lend up to 100% or even 150% of its net worth to a state power company. As it turns out, both utility and PFC benefit from this concession.

Take Apgenco, the Andhra Pradesh government-owned holding company that controls state-owned power generating assets. Unlike the private sector, Apgenco does not execute projects on a separate SPV basis and all projects come under the Apgenco banner.

Now, if the RBI guidelines were in place for PFC, it wouldn’t be able to lend even a rupee to Apgenco for its new projects, since it would have already reached the 40% exposure limit with earlier loans. While RBI’s exemption on prudential norms for PFC was due to expire in March 2012, it has now been further extended for a another year. So PFC can continue business with state utilities, says Singh.

The easing of prudential norms isn’t the only ace up PFC’s sleeve. Another reason it stays afloat despite its exposure to the power sector is due to its ability to raise long term debt — something needed for any capital intensive infra project where loan repayments go beyond 10 years. Commercial banks mostly raise short-term debt and can’t dole out the huge sums infra and power projects need. Banks that offer such financing could face an asset-liability mismatch — something that’s already happening.

Meanwhile, as PFC’s lending continues, the reform agenda isn’t forgotten. States that are slow on power reforms such as, tariff revisions, are given a lower rating, so they pay a higher rate of interest — lending rate varies from 11.5% to 14% on average. PFC has also, on previous occasions, stopped lending to discoms if it feels they aren’t toeing the reform line or revising tariffs. Recently, after banks, PFC and REC put a pause on lending to some discoms, some states agreed to increase tariffs by 2-22%. (Of course, it’s a different matter whether these hikes are adequate.)

Now what?

Things may change a little now. The current Five-Year Plan envisages an increased share of private sector lending (25%) by PFC. Currently, state and Central projects account for 82% of its lending, while the private sector constitutes only 10%  (the joint sector accounts for the remaining) — and this higher share of state and central hasn’t changed over the past years. Industry observers believe the company won’t have too much trouble meeting this target — since PFC focuses exclusively on power projects, unlike banks. 

The company has a three-tier security mechanism in place while lending to the private sector (not too different from other financial institutions). First, charge on assets. Second, depending on the borrower, it asks for collateral in the form of corporate guarantees, pledge of shares or personal guarantees. The third involves starting a trust and retention account with a third-party bank — all revenues of the project flow through this account and the bank is given instructions on how these revenues are to be used. In other words, the promoter does not have control over how the revenues of his project can be used.

Now, PFC is thinking of increasing its involvement at the third step, by acquiring a stake in a mid-sized bank where it can open these trust and retention accounts exclusively. “This way, we will have a say in the management of the bank, which will further protect our interests,” says Singh.

But the idea is still at a preliminary stage; PFC will need board approval before it can do this. The idea has its supporters. Former power secretary RV Shahi points out that unlike banks, PFC doesn’t have access to retail savings. “It takes loans to give loans while the cost of funds will be lower if it tapped retail savings. During my tenure, we initiated the process of PFC either acquiring a stake in a retail bank or itself starting a bank. However, the finance ministry didn’t allow this.” Indeed, PFC’s cost of funds at 9% is significantly higher than banks like SBI (6.1%). But then, while becoming a bank will help it lower its cost of funds, it will lose out as it will also have to comply with prudential norms applicable to banks, especially the exposure limits. More than PFC, states may have more to lose if this happens. 

Of more immediate concern is the fuel supply shortage and its impact on power plants. How will PFC be affected? Not too much, says Singh confidently. In the past three or four years, PFC has faced three defaults — not on loans to state utilities but to private sector projects. Of these, only one default — the Konaseema project in Andhra Pradesh — was on account of fuel shortage. “These issues will be sorted out in the next couple of years,” says Singh, adding, that is when the repayment schedule starts for many of the company’s projects. Plant shut down for fuel shortages were rare in the past, but things are changing now. 

On March 18, 2012, individual units of eight important plant stations, including both coal and gas-based plants, shut down production for lack of fuel. If this spreads, it may be a big risk to PFC’s asset quality in two years. Still, the company is taking no chances. It is diversifying funding to more areas, albeit still in the power sector: instead of focusing only on conventional projects, PFC is now funding renewable energy projects and equipment manufacturing. 

Will all this be enough to keep the company on its current growth trajectory? Most of PFC’s lending is toward state generation and transmission companies. But the real financial losses of the power sector are at the distribution end. “If that situation is not corrected, PFC will ultimately face the impact of the losses,” warns Shahi.