The current article aims to highlight the key aspects of the business of thermal power generation companies. After reading this article, an investor would understand the factors that impact the business of thermal power plants and the characteristics that differentiate a fundamentally strong thermal power producer from a weak one.
Key factors influencing the business of thermal power producers
1) Huge regulatory control on the thermal power sector:
Electricity is one of the most essential resources for any economy and society to function smoothly. The availability of good quality power is one of the biggest infrastructural requirements for businesses to grow and for people to live their life comfortably.
As a result, all the governments across the globe keep tight control on the power sector and more importantly on the thermal power sector because even today, it is the biggest source of power.
As per the credit rating agency, CARE, in FY2022, thermal power contributed to about 84% of total power generation in India whereas it constituted about 58% of installed capacity.
Rating Methodology – Thermal Power Producers by CARE, August 2022, page 1:
total installed capacity of electricity generation is 402.82 GW, with 236.1 GW (i.e., 58.6%) being contributed by thermal as of May 31, 2022….The thermal generation in India was 1,114.7 BUs in FY22, which contributed to 84.39% of the energy supply.
Therefore, almost every aspect of a thermal power plant including construction and operation is tightly controlled by the government. The regulatory control is exercised in the form of approvals for the submitted construction plans, land acquisition, forest and environment approvals, tariff increases & changes approvals, power purchase agreements, influencing the availability of raw material (fuel) from domestic as well as imported sources and much more.
The regulatory control over thermal power plants is so much that they cannot imagine functioning in an unregulated free marketplace. One of the key reasons for such a situation is that such power plants consume national and international resources at a massive scale and leave a very high impact on the both local natural and local socio-economic environment.
Thermal power plants have a large requirement of land for the plant, of fuel (coal or gas), which needs huge logistics infrastructure (railways or pipelines) to enable fuel movement from domestic as well as overseas locations. The power produced requires a huge transmission infrastructure to transfer it from the plant to consumers located far away within the state as well as outside states.
The scale of resources required in the case of thermal power plants is simply humongous. Therefore, invariably at every stage of their construction and operation, the state has to get involved, which increases the regulatory control on thermal power producers.
However, nowadays, governments across the globe, including India, have started to loosen their tight regulatory grip on the thermal power sector. Regulations now promote private investments in the power sector and have also partially allowed market forces of demand and supply to influence power prices.
However, even now, every significant change in the operating environment of thermal power producers involves government influence. We will continue to notice it throughout this article as we discuss various aspects of the business of thermal power plants.
Advised reading: How to do Business Analysis of a Company
2) Capital-intensive nature of thermal power production:
Construction of thermal power plants whether based on coal or gas requires a significant amount of investment. In addition, plants require continuous spending of money for maintaining and upgrading equipment. This large requirement of money acts as an entry barrier for new players.
Rating Methodology by Sector – Electricity by Rating and Investment Information, Inc. (R&I), Japan, December 2022, page 11:
electric power business is a typical capital-intensive business, and investments for new facilities and upgrades within any given period are indispensable for stable supply
In fact, the large investment required to enhance thermal power production is one of the key factors that forced governments across the globe, including India, to open up the sector for private investment. In the recent past, when the growing economies of many countries required enhanced power requirements, then acknowledging large investments and the inability of the public sector to meet them, governments opened up the thermal power sector for private investment.
For example, in the 1990s, Malaysia opened up the power sector for the private sector through the entry of independent power producers (IPPs) so that it may share the burden of required investment.
Rating Methodology – Independent Power Producer by Marc Ratings Berhad (MARC), Malaysia, January 2022, page 1:
In 1992, IPPs were allowed to enter the national power generation sector to transfer the burden of power plant financing from government-owned electricity utilities to the private sector.
On the same lines, in India, the entry of the private sector in thermal power production was promoted by Electricity Act 2003, when the requirement of a license for thermal power production was removed.
Rating Methodology for Thermal Power Producers by ICRA, July 2019, page 1:
A large portion…came from the private sector. This was possible following…enactment of the Electricity Act in 2003, which led to fundamental changes in the power sector, including de-licensing of thermal generation
Due to the entry of private players, the power generation capacity increased at a sharp pace and the power deficit in India declined sharply. The peak power deficit declined from 12.7% in FY2010 to 0.7% in FY2020.
Rating Methodology – Thermal Power Producers by CARE, July 2020, page 4:
The peak deficit in India which stood at 12.7% in 2009-10 has significantly reduced in the recent times to 0.7% in 2019-20 with the increase in supply aided by significant capacity addition which has outpaced the demand growth.
As a result of the capital-intensive nature of business, thermal power plants raise large debt. The regulators also acknowledge it and therefore, have allowed a debt-to-equity ratio of 2.33 or debt and equity contribution of 70:30 respectively for thermal power projects.
Rating Methodology for Thermal Power Producers by ICRA, April 2017, page 3:
Given the capital intensive nature of power generation projects and the regulatory normative debt-equity ratio allowed of 2.33 times, such projects tend to have a high leverage.
Due to high debt, any adverse development in the operating environment of the thermal power sector quickly affects its business and financial position, which also influences the banking sector because stress in the thermal power sector leads to large non-performing assets for banks.
As a result, when the thermal power sector faces industry-wide challenges, the govt. and regulators intervene to provide relief to the power sector.
For example, in the past, when power producers faced challenges in receiving payments from financially-weak distribution companies (discoms), then on multiple occasions, Govt intervened to ensure payments to power producers.
First, in 2012, Govt. of India made state governments take over 50% liabilities of discoms and provide guarantees to the balance 50%.
Rating Methodology for Thermal Power Producers by ICRA, February 2015, page 1:
scheme was notified by GoI in September 2012…As part of this scheme, 50% of short term liabilities of the utility are to be taken over by respective State Government and balance 50% is restructured with 3 year of moratorium period & backed by State Government guarantee.
Financially supporting discoms is one of the ways how Govt. supports power generation companies because distribution companies are the major customers of power producers. As a result, financially-stressed discoms delay payments to power producers, which deteriorates their financial position.
Ratings criteria for the power sector by CRISIL, Oct 2022, page 7:
financial viability of gencos is intricately linked to the financial position of the distribution sector, which is the primary offtaker.
In 2015, the Govt. came up with the UDAY scheme in which 75% of the debt of distribution companies was taken over by state governments.
Rating Methodology for Thermal Power Producers by ICRA, April 2017, page 2:
UDAY scheme involves takeover of 75% of the debt on the books of the distribution utilities by the respective state governments
Govt. has to take such steps to ensure that the financial stress in the power sector does not spread to other sectors via adverse impacts on the banking sector, which might affect the flow of money in other sectors of the economy.
Advised reading: How to do Financial Analysis of a Company
3) Challenges in the sale of power:
Nowadays, the sale of power by way of long-term power purchase agreements (PPA) has become challenging because not every plant is able to secure a long-term PPA. Many plants have to rely on medium and short-term PPAs, which do not cover the entire tenor of debt repayments, which exposes these plants to risk of adverse impact on power tariff at the time of renewal especially if their current tariff is at a higher level than the market price.
Rating Methodology – Thermal Power Producers by CARE, August 2022, page 3:
Medium-term PPAs…carry relatively higher risk as these generally do not cover the full loan tenor and the company’s ability to timely renew the same at remunerative tariff is evaluated.
In addition, many plants are not able to secure any contracted PPA and have to sell power in spot sales, which contains the highest sales risk both for the amount of power sold as well as the price of power.
Rating Methodology for Thermal Power Producers by ICRA, November 2021, page 6:
A significant portion of the capacity in the private IPP segment does not have long-term PPAs. Such projects remain exposed to volume and price risks in the short-term market.
Even if a power plant is able to secure a long-term PPA, even then it has to bid competitively to get the PPA resulting in lower profit margins due to intense competition. As discussed above, discoms are mandated to buy power by competitive bids and not by cost-plus tariff agreements.
In addition, with the emergence of power exchanges, especially in global markets, a new set of power suppliers have come up who buy electricity from power exchanges and supply it to customers. These new players (power traders) have intensified the competition leading to suboptimal operations of thermal power plants including shutdowns.
In Japan, the emergence of power traders has impacted power plants so much that due to stress on power producers, the stability of power availability has come under threat.
Rating Methodology by Sector – Electricity by Rating and Investment Information, Inc. (R&I), Japan, December 2022, page 5:
As new power suppliers using the wholesale electric power market increase their shares, adverse effects have emerged, including acceleration in power plant shutdowns and a tight power supply-demand situation, posing a challenge of ensuring stable supply.
As a result, there are demands for implementing measures to ensure a sufficient return on capital for power producers.
Rating Methodology by Sector – Electricity by Rating and Investment Information, Inc. (R&I), Japan, December 2022, page 5:
Rebuilding a mechanism that allows companies to properly recover the cost of their electricity supply is essential, and the progress in this regard is a critical factor that significantly affects the certainty of their investment recoupment.
Therefore, due to the long-tenure nature of PPAs, if any thermal power plant is enjoying a cost-plus tariff with pass-on for the increase in costs, then it is a big advantage over its peers.
Apart from such competition, another factor that poses a challenge for thermal power plants is constantly changing power sector norms, especially emission norms, and mining norms, both within India and overseas as well as customs duties etc.
Therefore, frequently, a power tariff, which was remunerative at the start of PPA becomes unviable later on. However, it becomes very difficult for thermal power producers to get a compensatory tariff hike from discoms, which impacts their viability.
Rating Methodology for Thermal Power Producers by ICRA, November 2021, page 3:
The thermal power producers also remain exposed to the funding constraints for the additional capital expenditure required to be incurred towards the installation of emission control equipment in the absence of a mechanism for its recovery through tariff
Most of the regulator-directed tariff increase is non-sufficient to cover the costs and comes very late. Therefore, the discoms as well as power generation companies suffer an impact on their financial performance.
Rating Methodology for Thermal Power Producers by ICRA, July 2019, page 2:
Further, the tariff revision approved by the state regulators has remained lower than the revisions agreed to in the UDAY MoUs. This has slowed down the loss reduction process for the discoms
Even in cases where thermal power producers enter into a long-term PPA, they face frequent delays in the collection of money from discoms because most of the discoms are financially weak and frequently require govt. support to clear their dues to thermal power generators.
Rating Methodology – Thermal Power Producers by CARE, August 2022, page 5:
the majority of the state Discoms in India has a weak financial profile, and they demonstrate a delayed payment track record for varying periods of delays which typically constrain the rating for a project
However, despite facing payment delays, thermal power projects have to suffer because it is not easy to get out of a PPA. In most cases, once a power producer enters into a PPA, then it is stuck with the buyer/discom for the duration of the PPA.
Rating Methodology – Thermal Power Producers by CARE, August 2022, page 5:
Counterparty risk could significantly impact the credit quality of the project as there is a long-term tie-up of the project with the off-taker with minimal chances to move out of it.
Therefore, it is very important to assess the financial strength of the buyer/discom of power from the thermal power plant while projecting the financial performance of the power plant in the future.
Further advised reading: How to analyse New Companies in Unknown Industries?
4) Challenges in the construction and operations of thermal power plants:
A thermal power plant requires a large parcel of land; therefore, it faces the challenging task of land acquisition. Alongside this, it requires various permissions like environmental clearance, which usually take a substantial amount of time and have the risk of delaying the project with cost escalations.
Rating Methodology for Thermal Power Producers by ICRA, November 2021, page 3:
issues related to land acquisition, rehabilitation and resettlement, and examines the status of various statutory clearances…As the process of acquiring the various clearances is vulnerable to delays, permitting risk tends to be the major focus area
Rating Methodology – Thermal Power Producers by CARE, August 2022, page 2:
Land acquisition and project-related approvals are considered to be very critical…as this activity usually takes maximum time in the entire implementation schedule of the power project.
In the past, thermal power plants faced significant delays due to land acquisition and other approvals-related issues; therefore, govt. changed the previous rules (Case-I) and brought in new rules (Case-II) in which a govt. nodal agency takes the project-related approvals and does land acquisition. It has reduced the risk in the construction of thermal power plants.
Rating Methodology – Thermal Power Producers by CARE, August 2022, page 2:
The projects being developed under Case-I competitive bidding mechanism where land acquisition and all related approvals are to be obtained by the developer are relatively riskier as compared to the projects under the Case-II mechanism where the responsibility of arranging land and project clearances/ approvals rests with government nodal agency.
After a thermal power plant has received all the approvals, then when it starts construction, even then, it faces the challenges of completing a large project within stipulated timelines. In case, the power plant has already signed a PPA, then it is contractually bound to meet the plant commissioning date; otherwise, it faces financial penalties.
Even if the power plant is ready on time, still, it is not able to sell power until the transmission line from the power plant location to the nearest grid substation is ready, which many times, may delay the evacuation of power from the plant.
Rating Methodology – Thermal Power Producers by CARE, August 2022, page 2:
Any delay in the construction of transmission infrastructure can cause the plant to remain idle despite becoming ready to generate power.
Many times, thermal power producers enter into engineering, procurement and construction (EPC) contracts with third parties and include penal clauses for delays to reduce construction risk. However, in such cases, the financial position of the EPC contractor to pay damages in the eventuality becomes important; otherwise, the power producer would not be able to recover penalties from the contractor.
Rating Methodology for Thermal Power Producers by ICRA, November 2021, page 4:
Fixed-price, fixed-time contracts, with adequate clauses for liquidated damages (LD) are usually the mitigating factors against the construction risk…ICRA also assesses the creditworthiness of the EPC contractor…its ability to pay the LD charges to the developer in case the situation arises.
Similar to construction, power plants employ operating and maintenance (O&M) agencies to reduce the risk of routine day to operations and maintenance of thermal power plants. The O&M contract will require the O&M player to ensure smooth operations of the plant and will stipulate penalties for suboptimal performance.
Rating Methodology – Independent Power Producer by Marc Ratings Berhad (MARC), Malaysia, January 2022, page 8:
performance risk of the power plant is usually mitigated through the appointment of an O&M contractor. The O&M contract typically addresses the minimum performance standards of the plant, and will specify damages for operation-related losses.
However, many times, the performance of thermal power plants is impacted significantly by external factors like availability and cost of fuel over which the O&M contractor has no control.
As thermal power plants need a lot of fuel (coal, gas etc.) and water; therefore, having necessary arrangements/tie-ups for sourcing water and fuel are essential. As thermal power plants use a lot of water, their operations may adversely impact local water resources and may cause local discontent.
Availability of coal for thermal power plants is a persistent challenge because coal as a precious national resource is essential for the operation of many sectors and at times, thermal power producers are not able to buy coal from domestic sources. This forces them to import coal, which is costly and may make their operations unviable.
Rating Methodology for Thermal Power Producers by ICRA, February 2015, page 1:
Domestic coal shortages coupled with changes in mining regulations in Indonesia led to cost escalation for many private power generation projects leading to their PPAs turning unviable.
When the Indian govt. had mandated competitive bid-based PPA for discoms, then it was assumed that thermal power plants would get sufficient coal from domestic mines or their captive mines overseas e.g. Indonesia.
Rating Methodology for Thermal Power Producers by ICRA, February 2015, page 1:
National Tariff Policy…recommended adoption of competitive bidding route for signing of PPAs…w.e.f. January 2011. For domestic coal based projects, the competitive bids assumed adequate availability of domestic coal either through linkage or captive coal block mining, while for imported coal based projects, the bids assumed availability either at a negotiated price level or through captive mining route in the overseas market – mainly in Indonesia.
However, soon, an increase in thermal power generation capacity exceeded the pace of domestic coal production and govt. had to restrict coal allocation for newer power plants (after 2009).
Rating Methodology for Thermal Power Producers by ICRA, February 2015, page 4:
With increasing domestic coal shortages for the sector, coal distribution policy was amended by GoI in September 2013…with restricted coal supplies mainly for the projects commissioned post March 2009.
Due to domestic coal shortage, the govt. allowed thermal power plants to import coal to the extent of shortfall in domestic coal. The govt. allowed for an increase in the PPA tariff to compensate for higher fuel costs. However, there was opposition from discoms, which had to bear the additional financial burden.
Rating Methodology for Thermal Power Producers by ICRA, February 2015, page 1:
While the GoI has approved a pass-through mechanism in June 2013 for allowing imported coal to the extent of domestic coal shortfall, implementation still remains uncertain given the opposition by the affected state owned distribution utilities and litigation challenges
Thermal power plants were further impacted when one of the major coal exporting countries, Indonesia, tightened its coal export policies, which made many thermal power plants economically unviable.
The regulators allowed for an increase in power tariff to compensate for such fuel cost increase for thermal power plants; however, it faced litigations from discoms.
Rating Methodology for Thermal Power Producers by ICRA, April 2017, page 6:
While CERC/SERCs have issued favourable orders for competitively bid-based projects affected by a change in regulations in Indonesia or domestic fuel shortages, allowing tariff compensation in few cases, uncertainty over implementation…due to litigation challenges by the affected state-owned utilities.
The risk of litigation and opposition from discoms also increases in such cases because usually, there are inconsistencies in the uniform application of regulations. Most such inconsistencies may arise due to subjective interpretation of regulations and the use of discretionary authority by regulators. Therefore, thermal power producers need to be ready to face such inconsistencies.
Electricity Power Industry – Key Success Factors by PT Pemeringkat Efek Indonesia (PEFINDO), Indonesia, November 2022, page 1:
Player must have flexibility to cope with the possible inconsistency on regulation implementation.
Regular payments from state-owned discoms as well as acceptance of higher tariffs from them seem very important for any thermal power plant to earn healthy returns; therefore, it seems that state-owned power producers are in a better position than private independent power producers (IPP).
Rating Methodology for Thermal Power Producers by ICRA, November 2021, page 1:
credit profile of central power generation utilities is supported by the presence of long-term PPAs under cost plus tariff principles, sovereign ownership and strong payment security, enabling regular recovery of payments from discoms
Those power plants, which have captive coal mines are better placed because they can get an assured supply of coal and are protected from fluctuating coal prices.
Rating Methodology – Thermal Power Producers by CARE, August 2022, page 4:
plants which have supply from captive mines tend to enjoy improved coal availability too at a competitive rate
Advised Reading: Credit Rating Reports: A Complete Guide for Stock Investors
5) Cost-efficient thermal power plants have a significant competitive advantage:
With the onset of competitive bidding for power purchase by discoms, thermal power plants have a huge pressure to be operationally efficient and produce power at the lowest possible cost.
As per the current regulations, discoms have to purchase power from producers as per the merit order. In the merit order, power producers with the lowest variable cost of production are placed at the top and those with the highest variable cost of production are placed at the bottom.
Ratings criteria for the power sector by CRISIL, Oct 2022, page 9:
Each distribution utility is mandated by the regulator to procure power based on a merit order dispatch, with the least priority set for the plant with the highest variable cost.
Therefore, in the current competitive bid-based environment, it becomes highly important for being as cost competitive as possible; otherwise, they would not be able to sell power profitably even after spending significant money on the power plant.
To bring in higher efficiency in the usage of power plants, govt. plans to start centralized power scheduling in which the lowest cost of power producers will be preferred. It further increases the importance of efficiency in the cost of production by power plants.
Rating Methodology for Thermal Power Producers by ICRA, November 2021, page 6:
there is a proposal to move to a market-based economic dispatch with discoms procuring power from the lowest cost producers through centralisation of power scheduling at an all-India level. This could benefit the power generating companies having competitive cost of generation and without long-term PPAs currently.
Moreover, a thermal power producer with a low cost of power production can better face challenges related to its PPA counterparty i.e. if the counterparty discom delays payments beyond a stipulated limit, then the low-cost power producer can sell the power in the open market at a profit.
Rating Methodology for Thermal Power Producers by ICRA, July 2019, page 5:
A generating company with a competitive cost structure can also explore other avenues for sale of power, including sales to bulk customers, which can reduce the payment risks associated with selling to state-owned distribution utilities.
Moreover, being cost-efficient is also important because thermal power producers cannot get an increase in tariff easily whereas their fuel costs are volatile and can increase to make their operations unprofitable.
Electricity Power Industry – Key Success Factors by PT Pemeringkat Efek Indonesia (PEFINDO), November 2022, page 1:
A good operating track-record will support player to manage cost because tariff is not flexible and fuel cost is unpredictable.
Advised reading: Operating Performance Analysis: A Simple & Complete Guide
Let us see the business strategies employed by power plants to gain a competitive advantage over their peers.
6) Large, diversified and integrated thermal power producers have a significant competitive advantage:
One of the ways for thermal power plants to become cost-efficient is to bring in economies of scale, which allows them a higher negotiation power over suppliers and brings in cost benefits in the purchase of raw materials like fuel.
Rating Methodology by Sector – Electricity by Rating and Investment Information, Inc. (R&I), Japan, December 2022, page 9:
Electric power is a typical capital-intensive industry, with benefits of scale easy to achieve from a capital equipment and fuel procurement aspect.
At times, a thermal power producer with a large market share may also influence the regulations in its favour.
Electricity Power Industry – Key Success Factors by PT Pemeringkat Efek Indonesia (PEFINDO), November 2022, page 1:
Strong market position favors player that captures the growing demand, creates recognition and increases bargaining power to supplier and regulator.
The importance of the large size of operations is so much that as per S&P, only large independent power producers are eligible to get an excellent rating on the parameter of competitive position.
Key Credit Factors for the Unregulated Power and Gas Industry by Standard & Poor’s (S&P), March 2014, page 5:
structural challenges facing the industry, its capital intensive nature, and the importance of scale also mean that only the largest unregulated power and gas companies…are likely to be assigned a competitive position assessment of “excellent.
Apart from a better negotiation power with suppliers and regulators, a large size of thermal power plant operations also helps it obtain finance and achieve diversified operations, which is another parameter to achieve competitive advantage in the business model.
Rating Companies in the Independent Power Producer Industry by DBRS Morningstar, Canada, May 2022, page 6:
Larger power producers may have more leverage when negotiating contracts, greater access to the capital markets, stronger liquidity, better operational and geographical diversification, and could even influence prices in some markets
Diversified thermal power producers experience relative stability in their operations. Diversification in operations can be achieved on different parameters like customers, geography, fuel mix etc.
Rating Companies in the Independent Power Producer Industry by DBRS Morningstar, Canada, May 2022, page 4:
Geographic and technological diversification are also important credit considerations. The stability of any individual operator can arise from diversification by operating region, by customer, by fuel, weather effects, and regulatory and political factors.
Thermal power producers, which have signed PPAs with multiple discoms and other buyers are better protected from the financial weaknesses of any single customer.
Rating Methodology – Thermal Power Producers by CARE, August 2022, page 5:
CARE Ratings considers a contractual sales agreement with multiple off-takers as a better proposition in general when compared to a single off-taker as it provides benefits of diversification.
Power producers with plants in different locations are better protected from disruption in their operations from natural disasters like floods, and earthquakes as well as local socio-political and labour-related issues.
Rating Companies in the Independent Power Producer Industry by DBRS Morningstar, Canada, May 2022, page 7:
Geographical diversification can reduce the concentration risk related to regulatory and political intervention within a single market or jurisdiction.
Thermal power producers enjoying flexibility in their fuel mix can face fuel price volatility better than those power plants, which can use only one type of fuel.
Rating Companies in the Independent Power Producer Industry by DBRS Morningstar, Canada, May 2022, page 7:
Fuel and technological diversification can reduce the risk of operational outages caused by technological complexity
Therefore, a diversified thermal power producer is better placed than non-diversified players.
Integration of operations is another parameter that brings a competitive advantage to thermal power producers. Integrated entities, which are present in different segments like mining, power production, transmission as well as retail distribution are better placed because they can better handle issues in any one area of operations without impacting the entire company.
Key Credit Factors for the Unregulated Power and Gas Industry by Standard & Poor’s (S&P), March 2014, page 11:
We generally consider a greater degree of vertical integration as enhancing credit due to the greater of a company’s ability to withstand unexpected operational or market disruptions to any one aspect of the business.
In fact, S&P believes that due to risk in the business of power-producing companies, they do not deserve an investment grade rating until they have integrated operations unless they are market leaders.
Key Credit Factors for the Unregulated Power and Gas Industry by Standard & Poor’s (S&P), March 2014, page 4:
Generally, the more integrated an entity is from an upstream fuel supply base to providing retail products and services, the stronger its business risk profile. In the most deregulated and competitive markets, without some level of integration, we consider it is unlikely entities could achieve investment-grade ratings, except for those that dominate their sectors.
Advised reading: How to do Business Analysis of a Company
7) Entry barriers for new thermal power producers:
As discussed above, thermal power production is a high capital-intensiveness business due to a large upfront investment requirement for plant construction and thereafter regular investment for maintenance and upgrading the plant to meet emission norms. As a result, thermal power plants have a long-gestation period of 3-4 years.
Ratings criteria for the power sector by CRISIL, Oct 2022, page 10:
Gestation period for a thermal plant is 3-4 years
High capital needs with a long gestation period act as an entry barrier for new players in thermal power production.
Rating Methodology by Sector – Electricity by Rating and Investment Information, Inc. (R&I), Japan, December 2022, page 3:
The hurdles to full-scale entry, including the substantial investment and long-term construction period required to build a power plant, are high.
In addition, numerous regulatory approvals required to construct and commission a thermal power plant add to the entry barriers for thermal power plants. The socio-political issues due to large land acquisition, compensation payments, environmental damage with local air pollution and water depletion are some issues, which hinder new thermal power producers from coming up in any area.
Rating Companies in the Independent Power Producer Industry by DBRS Morningstar, Canada, May 2022, page 4:
significant barriers to entry, including large capital requirements, long developmental lead times, and a new facility approval process susceptible to regulatory, political, and social issues;
In addition, existing thermal power plants enjoy a lot of advantages like already existing PPAs, access to transmission & distribution networks as well as existing low-cost amortized assets provide significant advantages because a new thermal power producer has to spend a significant time & resources to gain the access to grid and customers.
Key Credit Factors for the Unregulated Power and Gas Industry by Standard & Poor’s (S&P), March 2014, pages 5 and 6:
Competition from new entrants is muted by the capital-intensive nature of physical power production, the cost advantage of power generation portfolios with amortized low-cost generation assets, and pre-existing access to transmission.
Existing thermal power plants with production assets already in use for many years enjoy a cost advantage over new players because the power production assets do not lose their relevance soon. The technology of power production assets is mature and does not change overnight. As a result, these assets continue to work and produce power for long periods.
Rating Methodology by Sector – Electricity by Rating and Investment Information, Inc. (R&I), Japan, December 2022, page 5:
the equipment that electric utilities possess is technically mature, and the risk of obsolescence is minimal…much of the equipment can be used for periods beyond the statutory useful life.
Therefore, it becomes difficult for new power producers to outcompete existing thermal power plants.
Moreover, due to very high regulatory control on the thermal power sector, govt. keeps a tight grip on the operating environment including pricing and resource availability. Companies cannot increase prices without govt. approval. In fact, the govt. via these controls ensures that thermal power producers are not able to earn excessive profits, which otherwise would increase the cost of everything in the economy.
Rating Methodology by Sector – Electricity by Rating and Investment Information, Inc. (R&I), Japan, December 2022, page 11:
electric power is also a regulated industry in which excessive profits are controlled, and the ROA is lower than in other industries.
As a result, when the thermal power sector is under stress, the govt. brings in supportive measures to help the existing power producers. These supportive measures include improving the financial position of discoms, availability of fuel like coal, purchasing power from plants without PPAs as well as helping power producers impacted by a change in laws within India and overseas.
Rating Methodology for Thermal Power Producers by ICRA, July 2019, page 1:
Government of India (GoI) has initiated several measures…SHAKTI scheme for allocating fresh coal linkages, the scheme for procuring power by an aggregator on a medium-term basis from projects without PPAs and directions to regulators for time bound disposal of change in law petitions, among others…The measures include use of domestic linkage coal for short-term PPAs, regular auction of coal linkages, increase in the quantity of coal for the power sector
Therefore, the above-mentioned entry barriers, cost advantages of existing thermal power plants as well as govt. supportive measures to existing power producers strengthen their position and reduce competitive threats from new entrants.
Advised reading: Margin of Safety in Stock Investing: A Complete Guide
8) Threat from renewable energy:
Nowadays, governments across the globe are promoting power generation from renewable resources like solar, wind, hydro etc. instead of thermal because of the resource-intensive and environmentally-damaging nature of thermal power generation. In addition, currently, the tariffs of renewable energy have become cheaper than thermal power.
As a result, the renewable energy (RE) generation sector gets preferential policy and financial support from the state. One of the measures taken by the state to promote renewable energy is to ask discoms to mandatorily purchase all the energy produced from renewable sources.
Rating Methodology for Thermal Power Producers by ICRA, November 2021, page 1:
thermal plant load factor (PLF) is also under pressure, because of the growing share of renewable energy (RE) in the generation mix, driven by the large capacity addition over the past few years amid the strong policy focus, besides the competitive solar and wind tariffs.
This presents a peculiar situation for thermal power generators because renewable power generation is not consistent like thermal power. Renewable power production is concentrated over seasons (wind) and time of the day (solar). When renewable sources are producing power, then discoms ask thermal power producers to reduce or stop generating power.
Therefore, nowadays, thermal power producers need to be very flexible in their power production process.
Rating Methodology for Thermal Power Producers by ICRA, November 2021, page 4:
must run status accorded to the RE plants, the coal-based power generation projects are likely to face frequent back down requests and stoppages, especially in states with high RE capacity.
The focus of society on using renewable energy as much as possible at the cost of thermal power production leads to a reduction in the profitability of thermal power producers. For example, in Europe, increased production of renewable energy impacted the financial performance of thermal power plants.
Key Credit Factors for the Unregulated Power and Gas Industry by Standard & Poor’s (S&P), March 2014, page 9:
One example for the EU is the “20-20-20” targets (20% reduction in greenhouse gas emissions from 1990 levels, increased energy consumption produced from renewable resources to 20%, and improved energy efficiency by 20% by 2020), which have dramatically reduced profitability for Europe’s traditional power and gas companies.
Going ahead, the competition from renewable energy sources to thermal power plants is going to increase as with improving technology, the life and efficiency of renewable energy production are on the rise. An investor needs to keep this aspect in her mind while she projects the future performance of any thermal power plant.
Advised readings:
9) Declining govt support for the power sector:
Across the globe, whenever the thermal power sector is opened to the private sector, then initially, governments have given a lot of support to private investment through measures like power purchase agreements (PPAs) with attractive tariff structures. However, over time, after the initial investment projects stabilized, the govt. diluted the strong support and allowed market forces to influence the sector.
For example, in Malaysia, the initial private projects in the power sector were favoured very significantly by govt. to reduce the risk to the entrepreneurs; however, as the sector stabilized, then the govt. support and incentives declined.
Rating Methodology – Independent Power Producer by Marc Ratings Berhad (MARC), Malaysia, January 2022, page 1:
Compared to the earliest PPAs signed in 1993 and 1994 which were unconditional (binding for 21 years) “take-or-pay” PPAs, the second generation PPAs allow for the renegotiation of the PPAs in the event of industry restructuring. The agreed purchase price of power was also lower than the agreed tariffs in the earlier PPAs. Unlike in the initial PPAs, TNB does not absorb the force majeure risks in the subsequent PPAs.
Similarly, in India as well, after allowing attractive long-term PPAs with complete cost pass-through, later on, the govt. ruled out PPAs with cost-plus tariff arrangements and instead made it mandatory for all the discoms to follow competitive bidding for purchasing power.
Ratings criteria for the power sector by CRISIL, Oct 2022, page 8:
Since January 2011, competitive bidding has become mandatory for all power generation projects
From November 2013, even in the competitively-bided PPAs, the govt. has removed the prior practice of tariff quotes (fixed as well as variable) that were predetermined for the entire PPA duration. In order to bring pricing terms in line with the prevailing market condition; now, power producers can submit fixed quotes only for the first year. After that, these quotes change as per predefined benchmarks, which ensures that discoms do not end up paying a higher tariff even when market prices go down.
Rating Methodology for Thermal Power Producers by ICRA, July 2019, page 10:
The competitive bid based PPAs tied up by discoms till November 2013, constituted fixed and variable charges quoted by the developers for the entire PPA period…Under the revised bidding norms notified by Government of India in November 2013, the bidders have to quote fixed charges and variable charges for the first year, which will be escalated for subsequent years as per the pre-specified benchmark index
Moreover, when a lot of gas-based thermal power projects came up in India, which became unviable as they could not get cheaper domestic natural gas, then the govt. refused to support them with cheaper gas supplies. The govt. clearly told them that it did not promise them cheaper gas to ensure the viability of their plants (Source: Gas-based plants in India not viable: Piyush Goyal – Economic Times, Aug 07, 2014)
Gas-based plants in India are not viable because there is not enough gas in the country…”there was no assurance of gas being provided at any particular price or the availability of gas was not guaranteed to any of these plants,” he said.
Advised reading: How To Monitor Stocks In Your Portfolio
10) Environmental and social risk:
Thermal power plants are one of the major polluting industries because they burn fossil fuels (coal, gas etc.) to produce electricity, which produces gases that damage the environment. Moreover, the emission of these polluting gases cannot be stopped from thermal power plants.
Apart from air pollution, thermal power plants use a lot of water in the electricity generation process, which depletes scarce water resources. In addition, extraction of the fuel (coal) via mining damages the environment at the site of the mine and in the nearby areas.
Rating Methodology for Thermal Power Producers by ICRA, November 2021, page 12:
Coal-based power plants are one the leading emitters of pollutants and cause significant damage to the environment. Also, coal-based power plants are one of the largest industrial users of water. Further, the coal mining has an adverse impact on the environmental, especially on the flora and fauna in the coal mining region.
Therefore, thermal power plants are always the target of environmental activists and frequently governments keep strengthening the emission norms, which requires additional investment by power plants to reduce the emission of pollutants.
Rating Methodology for Thermal Power Producers by ICRA, November 2021, page 3:
The thermal power producers also remain exposed to the funding constraints for the additional capital expenditure required to be incurred towards the installation of emission control equipment
For example, recently, the govt. has asked thermal power plants near cities to install Flue Gas De-sulphurization (FGD) to reduce emissions, which has forced power plants to make investments to meet these emission norms.
Rating Methodology – Thermal Power Producers by CARE, August 2022, page 7:
Based on the location and proximity to cities, the thermal plants have been notified timeline by MoEF&CC to install Flue Gas De-sulphurisation (FGD).
Many times, the investment burden to meet emission control norms is significant and many thermal power plants are not able to meet it within expected timelines. The govt. realizing the investment burden frequently extends these deadlines. However, ultimately, thermal power producers have to meet the norms or close the plants.
Rating Methodology for Thermal Power Producers by ICRA, November 2021, page 3:
projects were required to comply with these standards by December 2017…the timeline was subsequently extended to December 2022…Recently, the MoEF further amended the rules and revised the timelines for complying with the revised emission norms by up to two years.
As a result, the significant investment requirement continuously to meet environmental norms adds to the capital-intensiveness of the thermal power sector and acts as an additional barrier to entry for new players.
In addition to environmental risks, thermal power plants also face social risks.
Thermal power plants require large land parcels, which necessitates purchasing land from numerous local people. Any discord with the local population in land acquisition increases the social risk that may result in a delay of the project including cost escalation.
In addition, thermal power plants employ many labourers, which are from the local population and usually form a union. Moreover, the environmental damage caused by a power plant may also lead to local unrest.
Rating Methodology for Thermal Power Producers by ICRA, November 2021, page 12:
Given the large land requirement for these projects, social risks manifest when there are disagreements over compensation between the developers and the land owners. Also, the adverse impact of air pollution by coal-based power plants in nearby localities could trigger local criticism…power generators are usually significant local employers that sometimes include highly unionised staff.
All these factors expose thermal power plants to significant social risk, which a thermal power producer has to deal with diligently.
Advised reading: Hidden Risk of Investing in High PE Stocks
Summary
The thermal power sector is one of the most critical segments of the economy for the country because of its biggest share in electricity production, which is the base for the smooth functioning of society. Therefore, govt. has put significant regulatory control on the thermal power sector.
Regulatory controls start from the planning stage with numerous approvals and influence every aspect of operations like sourcing of fuel (coal, gas etc.), sale of power (nature of PPAs, bidding criteria etc.), an increase of tariffs, power scheduling, emission norms etc.
Tight controls by govt. ensure that thermal power plants are not able to enjoy excessive profits and their return on assets is usually below other industries because the supernormal profitability of thermal power producers will impact the entire economy due to a higher cost of power.
Thermal power plants are very capital-intensive and require large upfront investment as well as continuous maintenance and upgradation spending to meet updated emission and other regulatory norms. Therefore, thermal power plants are usually large projects to enjoy economies of scale and have better negotiating power over suppliers and regulators.
Capital-intensive nature, numerous approvals, long time for construction and gestation period as well as govt. support to existing thermal power plants to relieve financial stress act as an entry barrier to new players keeping competitive threat low. However, with the emergence of power exchanges, new players involved in the trading of power have started posing a threat to established power plants, especially in developed markets like Japan.
Even though, the govt. has promoted private investment in thermal power production by removing licensing requirements, the direction of subsequent policy changes indicates that instead of an assured return on private investment, govt. wants them to share the market risk of demand & supply. Therefore, it has mandated competitive bidding for the signing of PPAs by discoms and has directed tariffs linked to predefined benchmark indices.
Apart from competitive bidding leading to lower profit margins, thermal power plants face challenges in receipt of payments from discoms because most of the discoms are financially weak. As a result, govt. has to take steps to strengthen discoms so that they can make payments to power plants, which in turn may avoid stress in the banking sector, which would otherwise impact the entire economy.
Therefore, govt. frequently takes supportive measures for thermal power producers like a regular auction of coal linkages, making a nodal agency buy power from plants that do not have any PPA, providing relief/higher tariffs for plants affected by changing regulations in India or overseas (coal export ban by Indonesia) etc.
However, due to an increasing focus on letting market forces play a greater role in the thermal power sector; nowadays, in some instances govt. has refused to use taxpayers’ funds to support numerous gas-based power plants, which could not get cheaper domestic natural gas.
Due to increasing market-related dynamics, thermal power plants need to be as cost-efficient as possible. Because, now, discoms have to buy power from plants with a low variable cost of power production that are placed higher in the merit order dispatch system.
In order to be more cost-efficient, thermal power plants have to increase their size of operations to gain economies of scale as well as go for integrated operations as well as geographical, customer, fuel and technological diversification to bring stability to their operations.
Thermal power plants face a lot of environmental and socio-political risk due to a large land acquisition exercise involving negotiations for compensation with numerous landowners, the polluting nature of power plants’ operations, depletion of water resources as well as environmentally damaging nature of coal mining operations. In addition, the use of large local unionised labour requires that thermal power plants handle local socio-political and environmental issues with diligence to avoid any disruption of their operations.
Therefore, an investor should always keep in mind these multiple aspects of thermal power producers to understand the true picture of their business position.
- Huge regulatory control on every aspect of operations of thermal power plants
- Highly capital-intensive business with a continued requirement of an investment of funds for stable power production
- Increasing challenges in earning a good return on capital due to progressively more roles of market dynamics in demand and supply.
- Long gestation period with significant risk in construction and operations including sourcing fuel and water for power production
- Mandatory focus on cost efficiency due to preference for lowest cost power producers in the merit order dispatch system
- The large size of operations, geographical, customer and fuel diversification and integration of operations help thermal power producers in getting competitive advantages over peers
- Large capital needs, a requirement of numerous approvals, long gestation period act as entry barriers for new players
- The emergence of renewable energy as well as power traders have intensified competition in the sector, which has led to frequent scaleback of power production by thermal plants including shutdowns
- Govt. wants to shift the burden of investment in power generation assets to the private sector and does not want to use taxpayers’ money to provide them with an assured return. Therefore, thermal power producers are no longer able to earn an assured high return on their investment
We believe that if an investor analyses any thermal power producer by keeping the above factors in mind, then she would be able to assess its business properly.
Regards,
Dr Vijay Malik
P.S.
- Subscribe to Dr Vijay Malik’s Recommended Stocks: Click here
- Chennai “Peaceful Investing” Workshop | 26 July 2026: Register Here
- To learn stock investing through videos, you may subscribe to the Peaceful Investing – Workshop Videos
- 25% savings on buying our Stock Analysis Excel Template and all ebooks together: Analysis Package: Excel Template + All eBooks (25% savings)
- To download our customized Stock Analysis Excel Template for analysing companies: Stock Analysis Excel
- Learn about our stock analysis approach in the e-book: “Peaceful Investing – A Simple Guide to Hassle-free Stock Investing”
- To learn how to do business analysis of companies: e-book: Business Analysis Guide
- To pre-register/express interest in a “Peaceful Investing” workshop in your city: Click here
Disclaimer
I, Vijay Malik, am a SEBI-registered Research Analyst (Regn. No. INH100008364). This article is for educational purposes only and does not constitute investment advice or a recommendation to buy or sell any securities. Investors should do their own research before making any investment decisions.
I, or my immediate relatives, do not have any financial interest in the companies discussed as on the date of publication of this article, nor do we hold one per cent or more of the securities of such companies at the end of the month immediately preceding it. I do not have any material conflict of interest and have not received any compensation or other benefits from the companies or any third party in relation to this article during the 12 months preceding its publication. I have not served as an officer, director, or employee of the subject companies, nor have I been engaged in market making activity for them.
