Greek history records Diocletian as the ruler of the Roman empire from 284 AD to 305. Historians and economists observe that the only noteworthy event in his largely event-less tenure was the issuance of an “edict of maximum prices” in 301 BC. It was his attempt to curb high prices by using price controls, the first such instance in recorded history. Its dramatic failure was due to the all-too-familiar causes—black marketing of commodities, reduction of production of goods, and a great increase in the quoted price of transportation to offset the low price of goods. Mankind learnt its first lesson in price control—that the market always finds a way to price goods remuneratively.
This past week, various reports indicate that the Union government’s bright idea to keep power tariffs low is the following—a reverse auction for blocks allotted to the power sector, with the ceiling price being the Coal India Ltd (CIL) Run of Mine price of equivalent grade. The rationale is that if the bid price of coal is capped at CIL’s notified price, the resulting power tariffs should remain capped.
However, just as Diocletian failed to realise, this logic is flawed at many levels. For one, the concept of capping the bid price with CIL assumes that it is technically possible to produce coal cheaper than CIL’s price. While one would logically assume that the private sector can better CIL’s inefficient cost of production, it is also important to bear in mind that historically CIL has always had the pick of coal mines with extremely low strip ratios and far superior evacuation infrastructure. Further, CIL is a largely-debt-free company with extremely low cost of capital, and can afford to produce and price coal at levels which are difficult to achieve in the private sector. Benchmarking captive coal block prices to this is illogical, and is definitely not reflective of the fair cost of producing coal from these blocks.
Secondly, the reverse auction methodology assumes that the price bid would reflect the production efficiency of the bidder. In other words, the bidder would only bid as much as it costs to produce coal, with a reasonable profit margin. However, several bids by states (such as a joint block owned by Maharashtra and Tamil Nadu) in the Mine Developer Operator (MDO) space showed that bidders were able to submit irrationally aggressive bids, sometimes even negative rates for extraction of coal. In such cases, the bidder looks for another area of profit in the business, or, in this specific case, could merely load the price gap onto the fixed charges while bidding for power in the future. Thus, the power price, which is essentially the sum of the fixed charge and the cost of producing coal, could be much higher than before, and would be determined purely on competitive parameters of that specific bid. It would be naive to expect the private sector to price their bid for power (which consists of both fixed and energy charges) low simply because they received a coal block at a certain price. A recent case in point is the bids in Kerala, where the fixed charges were R2.98 (over 280% over the weighted average of bids in Maharashtra in 2009!)—a clear indication that bidders were loading the fuel charges into the fixed charge as the bid framework was not providing a renumerative charge for fuel.
Another crucial area of improvement in the proposed methodology is that it offers differential treatment to plants that have already tied up Power Purchase Agreements (PPAs), and plants that are yet to tie up their power under PPAs. Plants that have already tied up their PPAs merely get a pass-through of their bid-coal cost in power tariffs, while plants without PPAs get to participate in new bids with the power generated from such blocks. This gives them the flexibility to load any deficit in their coal bid in their fixed cost and participate in bids—a clear advantage over plants that have already tied up their PPAs.
Finally, capping bids at CIL’s Run of Mine price vitiates the entire concept of availability based tariff and merit order dispatch in the power market. In India, power plants are scheduled by states (or customers) on the basis of the “merit order”—that is, the available power is stacked up in ascending order of the energy cost (variable cost) of the power, and is dispatched starting with the cheapest energy first. By linking the price of coal to CIL prices and encouraging power bidders to load the difference in the capacity charge, states would be left unable to figure out the actual cost of energy, and could result in substantial system inefficiencies.
The Greeks learnt from Diocletian’s error. It is time we do too, and avoid artificial ceiling prices on the bid price of coal.
Shravan Sampath
