(This blog was originally published on my personal blog- https://privateinvestor.substack.com on 26th April 2021)
Some investments draw much of their strengths from the very nature of business they operate in. In such cases, understanding of the very business and its value chain is important because that is what is working in favor of the company. Plus, if the company is the dominant player in such business, then you have a possible winner at hand.
In this post I’ll share my thoughts on the Power Exchange Business- the current structure, value proposition and the future ahead. Then we will also look into Indian Energy Exchange (IEX)- its dominance in Power Exchange Business, Optionalities and Risk Factors.
I’ll try and cover a lot of things, so let’s get right into it.
How The Power Infrastructure Works- Specifically the Distribution Part?
The main piece we need to understand here is how the distribution works. So, we as consumers are connected to our local transmission network which is owned by the State Transmission Utility. This local network is connected to the state network (again owned by State Transmission Utility), which in turn is connected to the national grid through inter-state transmission lines (ones owned by Power Grid Corporation). Similarly, a power plant somewhere is also connected to this national grid through a series of local/state/regional power lines.
In essence, everyone in the entire power ecosystem is connected through a network of local, state, regional and national transmission lines.
This interconnectedness and the fact that Electricity is a fungible commodity (electricity is same everywhere) makes electricity the best commodity to be traded on an exchange platform without any friction.
So, a Seller who is contracted to sell a specific quantity of electricity just has to pump that much electricity into the grid and a buyer who is contracted to buy a specific quantity has to pull that much electricity from the grid.
Discoms are key players in this value chain. Discoms buys electricity from Generators and Sells the same to consumers. It is this buying and selling between Discoms and Generators that makes up the power market.
Structure of Power Market In India
Indian Power Market in FY20 was close to 1400 Billion units (unit=Kilo Watt Hour). Of this 90% of the electricity gets traded under Long Term Agreements (>1 year contracts) and remaining ~10% is Short Term (<1 year contracts).
Long Term Power Market consists of PPA (Power Purchase Agreements). These are 25 years contracts between Discoms and Power Generators for supplying a specific quantum of electricity.
Short Term Power Market (STM) is for Buying electricity from next 1 hour to upto 1 year. And there are 4 segments in this market-
1.Direct Bilateral Transactions (20% of STM): These are direct transactions between various Discoms for buying/selling from one another. Discoms trades between themselves to sell any surplus power they have or buy to cover for any deficit.
2.Through Trading Licensees (22% of STM): These are transactions that happen through registered brokers who facilitate deals between buyers/sellers like Discoms and Power generators. The largest of them is PTC India (Power Trading Corporation).
3.Deviation Settlement Mechanism (DSM) (17% of STM): This is not actually a market activity, but rather a settlement mechanism that basically accounts for excess or shortfall in supply/demand done by Power generators and Discoms. So, for example, if a Discom was supposed to consume X units from the grid and ends up consuming more than those units, then the DSM mechanism would result in accounting for this excess consumption, resulting in Discom paying for excess consumption based on a specific price plus a penalty for deviating from its scheduled quantity.
4.Power Exchanges (41% of STM): A power exchange is basically a platform for Discoms, Generators, Traders (on behalf of its customers) and Open Access Consumers (bulk consumers of electricity who can buy directly from Generators) to buy/sell electricity.
Brief History Of Power Exchanges In India
Idea of a Power Exchange in India was floated in 2005. India currently has two power exchanges and they have come to dominate the Short-Term Power market with over 40% share of short-term market in FY20 and >50% in FY21.
Value Proposition of Power Exchanges
Power requirement is a dynamic in nature. Power usage varies between time of the day and night and it also varies between seasons. So, demand of power typically goes up in Summers due to cooling requirement whereas it goes up in the evening due to lighting needs. The generation of power can also vary due to multiple reasons, especially for the renewable sources like Solar and Wind. Solar generation peaks during noon.
Power exchanges allows buyers/sellers flexibility to buy/sell different quantum of electricity not only for each day, but also for each block of 15 mins.
The chart below lays out how a buyer in Telangana was able to buy varying quantum of electricity over the course of a day depending on its requirement; similarly, a seller in Haryana was able sell varying quantum of electricity based on availability.
Such flexibility is not available through other modes of power trading. In case of long term PPAs, a buyer even has to pay a fixed cost per unit for the contracted quantum of electricity irrespective of how much power the buyer actually requires for any given period.
Power exchanges also allows buyer/sellers to transact in a very short notice period of just 1 hour. So, if a discom is witnessing increased demand, it can buy the same on the exchange and get delivery of the same in just 1 hour. This allows buyers/sellers to manage their requirements in real time. In any other mode, it will take days/weeks to enter into contracts for additional requirements.
2. Competitive Pricing
Power exchanges allows for better and efficient price discovery. All bilateral deals are largely one-to-one transactions, whereas Power exchange is a market mechanism wherein price is determined based on demand-supply dynamics.
Prices on power exchanges have always been competitive compared to bilateral deals done through traders.
Further, pricing on power exchange is non-discriminatory in nature. In bilateral deals, pricing is heavily influenced by quantum and credit standing of the buyer. Whereas, exchange allows for similar & transparent pricing for all participants, especially for the marginal players.
3. Payment Guarantee
Discoms owes Power generators over 1.2 lakh crores in outstanding payments for power purchased under PPAs. These large dues are result of the broken business model of discoms in India, wherein the purchase costs of power for most discoms are higher than revenues. And such mismatch is due to two primary reasons of inefficient management of discom and subsidizing power for political motives.
Power exchanges collects upfront margins from participants and payments are settled in 1-2 days of transactions. Further, a power exchange also guarantees payments for each participant in case of default by another party by maintaining a settlement guarantee fund. This is a big positive for sellers on the power exchanges.
4. Other Value Additions
Exchanges acts as a price discovery mechanism for other parts of the power value chain. Prices for deviations under DSM are based on price discovered on power exchanges.
Further, power exchanges will also provide price benchmark for the derivatives markets. IEX and MCX have recently entered into an agreement for the same.
Some products like Renewable Energy Certificates (explained later) are traded exclusively on the power exchange and not at other places.
With better pricing, flexibility in buying/selling, payment guarantee and overall ease of transacting through power exchanges; power exchanges have come to dominate the short-term power market.
Below are few snippets from news articles, wherein State discoms highlights the benefits of transacting through exchange.
Power exchange will gain more dominance going ahead as more areas opens up. Currently, power exchanges offer the following products-
1.DAM (Day Ahead Market)
This is the primary offering of the exchanges and accounts for over 80% of volumes on exchange. Under this product, transactions occur for delivery of electricity for the next day.
2.TAM (Term Ahead Market)
Term Ahead Market includes products for delivery of electricity for upto 11 days. It includes daily & weekly contracts, intra-day contracts and day-ahead contingency. This segment is small and constitutes about 5-8% of volumes.
3.RTM (Real Time Market)
This segment was launched in June’20 and has been a big pivot for power exchanges. Till RTM, the lowest time gap between transaction and delivery of electricity on power exchange was 2.5 hr, through the intraday contract, which was not very liquid.
The reason for this was that, under a typical PPA, any buyer ie Discom has the right to demand power from power generator with just 1 hr notice. This meant that the entire capacity tied in PPA would never come to power exchange directly, because generators were obligated to hold the capacity till the last 1 hr and the latest possible delivery opportunity in exchange was with a lag of 2.5 hr. With, RTM that duration has now reduced to 1 hr and regulations have allowed power generators to sell uncalled capacity under PPA to be sold on power exchange. This has allowed power exchanges to provide a very liquid market with a very short delivery lag to buyers/sellers.
RTM now accounts for over 10% of exchange volumes within its 1st year of launch.
4.REC (Renewable Energy Certificates)
Regulations require each power consumer like discoms to source certain percentage of their power requirements from renewable sources. This is called Renewable Purchase Obligation. This obligation can also be full-filled by buying something called as Renewable Energy Certificates. RECs are issued to renewable energy generators to signify the renewable aspect of electricity generated. Such renewable generators can then sell the same to buyers on power exchanges, who can use the same to compensate their renewable purchase obligation.
This segment contributes 10-15% of exchange volumes.
5.G-TAM (Green Term Ahead Market)
This product was also launched in the later part of 2020 and is same as TAM product as discussed above, but for renewable energy. So, transactions that take place here will include an energy component as well as a renewable purchase obligation component as well. The volumes here are very small currently.
Currently, Power exchanges are limited to offering products upto 11 days. Whereas, Short term market is upto 1 year. Power exchanges are under process of introducing long duration contracts, which will allow transactions of upto 1 year on power exchanges. This will expand the scope of power exchange to almost entirety of Short-Term market.
Snippets from Q2FY21 Concall of IEX, wherein management talks about expanding scope of Exchanges in Short Term Market.
Share of Short-Term Market in Overall Power Market
Based on what we have discussed till now, we can understand that Power Exchanges are a better way of transacting electricity and also that they will increasingly have larger share of the Short-Term Market.
But for Power Exchanges to continue to grow for very long period, the share of Short-Term market in overall power market also has to increase. Currently, Short Term market is ~11% of total power market. This number has been constant at ~10% over last several years.
The reason for this is largely the inefficiencies of Discoms and constraints on Power Exchange. But there have been multiple initiatives which over time should increase the share of Short-Term market, largely driven by growth in volumes at Power Exchanges.
Government is keen on privatizing discoms in order to improve their efficiencies. Government has already announced privatization of discoms of all Union Territories. Further, government is also looking to move a proposal wherein everyone would have an option to choose their power supplier. This would basically mean that any company can take up power distribution in any area by using the transmission infrastructure of state discoms. This increased private participation is key as private players will look to source power in the cheapest and most efficient manner, which is through power exchanges.
Government is also looking to allow discoms to exit PPA with central power generators that have completed 25 years. This will free up capacity, some of which can make its way to the power exchanges.
2.Increasing Scope of Power Exchanges
As I had discussed earlier that power exchanges are working to introduce long duration contracts of >11 days and upto 1 year. Currently, long duration contracts are done on bilateral basis. Once the same are introduced through the exchange mechanism, then the same can gain traction, as such contracts on exchange will come with the flexibility and better price discovery offered by power exchange.
Further, along with Long duration contracts, regulations are also in place to launch electricity derivatives on commodity exchanges. This is a key enabler, as buyer/sellers will be able to hedge the price of electricity through derivatives and be more open to buy/sell on short term basis without worrying about volatility in prices of electricity in the short term.
Power exchanges have recently started cross-border trading as well. Indian power grid is also connected to some of our neighboring countries like Nepal, Bhutan and Bangladesh. Current trade with such countries stands at ~18 billion units though medium-long term bilateral contracts. This opens up new market for power exchanges.
3.Increasing Share of Renewables in India’s Power Sector
India has set big targets to increase share of renewables in its energy mix. India has hardly added any thermal generation capacity in last few years. Increasing share of renewables is good for short term market because, renewable power generation varies considerably and is outside human control. These variations would have to be met with real time power transactions on the power exchanges.
Globally, different countries have different share of Exchange market as a % of overall power market. This penetration depends on the structure that a country decides for its power markets. In India, Power exchanges accounts for ~6% of total power market currently.
But India is looking for a power market structure wherein 100% of power will be transacted on the Power Exchanges. This is a big Optionality for a Power Exchange.
MBED- The Big Optionality
MBED stands for Market Based Economic Dispatch. Under this proposed framework, entire power in the country would be transacted through the power exchanges, including the ones tied up in PPAs.
The whole idea here is that the power requirement of the entire country should be met with the cheapest power available.
Consider the following-
Disom A has a PPA with Generator A for 1000 units at a variable cost of Rs3 per unit.
Discom B has a PPA with Generator B for 1000 units at a variable cost of Rs5 per unit.
If on a given day both Discom A & B requires 500 units each, the total cost of power would be 500*3 + 500*5 = Rs4000. What if, Both Dicom A & B could have bought from Generator A, which is a cheaper power producer? In such case the total cost of power would be 500*3 + 500*3 = Rs3000. This saving is a result of using the capacity of cheapest power producer first.
Under current regime of PPA, this is not possible because each capacity is tied up exclusively to a Discom and in case of no requirement from such discom, the idle capacity cannot be sold separately to another discom.
Currently, each discom looks at its power requirement and then procures power based on a merit order of cheapest source of power within its PPAs. However, a source of power which is lower in the merit order for say a Discom A, can be a cheaper source of power for another Discom B.
What MBED proposes is that instead of each discom having their own merit order individually, we have a common pool with a single merit list of all power generators, such that cheaper sources are utilized fully. The way to do this is to have a common pool of demand of Discoms and Supply under PPA by power generators. And this common pool will be achieved on the power exchange.
One would ask, what happens to existing PPAs? Well, nothing changes. Discoms will continue to pay fixed charges to Power Generators separately.
If one is interested to read more in detail about MBED, then you can read this discussion paper on MBED (Click Here)
But, Timeline of MBED implementation is uncertain, the discussion paper on the same came out in late 2018. But current government is adamant on improving the dynamics of power sector, specially improving the health of Discoms which continue to face large losses. And one way to do this is through system wide reduction in power procurement costs. Further, Power Minister RK Singh has recently in few interviews mentioned that they are working on implementing economic dispatch of power.
Once this happens, the current share of power exchanges will move from ~6% to 100% and exchanges will see 15-20x jump in their volumes.
Even if share of Short-Term Market does not expand, then power exchanges are still well placed to grow in mid-low teens on the back on increased power consumption which grows at 5-6% ever year and gaining more share of the Short- Term market.
Based on above discussion, I think one would have a good understanding of the prospects of Power Exchanges. Now let’s talk about IEX (Indian Energy Exchange), which is the dominant power exchange and also a Listed company, which is what attracts us all here.
IEX commands more than 90% market share in the power exchanges volumes. The 2nd player- PXIL is a marginal player. The 3rd power exchange is currently under works and would be operational sometime in 2022.
The dominance of IEX is evident by a single fact that the current annual volumes of PXIL is less than the volumes done by IEX in its 1st full year in FY10.
*FY21 Volumes for PXIL is till January’21 only.
IEX charges 2 paise each from buyer & seller for facilitating trading of each unit (unit=Kilo Watt Hour) of electricity. This amount is regulated by CERC (Central Electricity Regulatory Commission).
In an exchange business, one typically expects operating leverage to play out i.e., your costs to run the business are fixed, but revenues will grow and thus profits will grow faster than revenues. However, in case of IEX, the EBITDA margins are already very high at 80% i.e., 80% of revenues is already flowing to the bottomline. Thus, incremental growth in revenues will not grow profits at a rate much faster than revenues, even though costs will not increase proportionately. The delta between 80% of revenues flowing to bottomline and 100% of profits flowing to bottomline is not huge. So, one should keep this in mind in case of IEX.
IEX currently enjoys monopoly in the power exchange business. A large part of this dominance is due to high liquidity that IEX currently enjoys in its platform. In exchange business, Liquidity attracts liquidity. We have seen in the case of BSE and NSE, wherein NSE enjoys most of the liquidity and thus most of the incremental business and BSE continues to be a marginal and secondary player. In case of power exchanges, we have the same equation between IEX and PXIL.
However, a new market framework can put this Liquidity advantage at risk for IEX.
The Dilemma of Market Coupling
In the recent regulations, government has put in a provision of something called a Market Coupling Operator. The role of this operator would be to collect all buy/sell orders from all the exchanges and then determine a single clearing price for all power exchanges. This basically means that the order matching and price discovery function of a power exchange would shift to the Market Coupling Operator.
This would mean that liquidity will no longer be an advantage for IEX, because irrespective of where a buyer/seller places its order, the end matching of orders will happen at a common liquidity pool at the market coupling operator.
This is one of the key risks that most investors associate with IEX. However, I do not think that this would be huge negative for IEX. One needs to understand the requirement of market coupling operator. The whole idea for market coupling is to determine a single price and to avoid situation wherein two separate orderbooks would lead to some orders not getting execute, which could have executed if liquidity from the other exchange was considered, which is your matching orders across the exchange. This is not required now because the volumes on exchanges are still low at just 6% of total trade. The requirement for a single order pool is very important when MBED comes into picture and entire 100% of power gets traded on the exchange.
Currently, market coupling has been introduced into regulations as an enabling provision, whether it will be implemented and the timeline of implementation of the same has not been decided.
I believe that instead of a risk, it is a positive indication for IEX as it hints at government’s intention of implementing MBED. Currently IEX has monopoly in a small market of just 6% of entire of power market. If MBED and Market Coupling are introduced, then IEX will not own 100% market share, but it will own dominant share of a very large market i.e., the total power Market. And 40-50% share of the 100% market is way better than 100% share of just a 6% market.
Once market coupling is in place the game for market share will shift from Liquidity to something else. Pricing should not be the factor given that exchange fee it is a very small component of overall power cost (<1%). My thoughts here is that, the role of power exchanges will become more or less like brokers, once MBED and Market Coupling happens. IEX and PXIL will collect orders, provide clearing, payments, support etc. Now I prefer Zerodha as a broker not because it is cheap, pricing is competitive for everyone now; but because I like their platform, I like their support and the fact that they keep adding new features. So even if some other broker offers lower prices, which some do, I will not switch.
So, platform and market development would determine the market share between the power exchanges. And IEX has been on the forefront when it comes to platform and market development.
Another good analogy given by the management on Market Coupling
PTC – The Real Risk
PTC (Power Trading Corporation) is the largest trading licensee in India. PTC facilitates trades between buyers/sellers trough bilateral deals and also act as a broker for participants on the exchanges.
The risk here is that 40% of volumes on power exchanges happens through PTC. So, when Liquidity is the key determinant, PTC can actually influence liquidity from one exchange to another. In future, if platform is the key determinant, then as well, a single entity might not really care which platform is good or bad, if the incentives are aligned, then it can look to shift volumes.
The good part has been that, there is no incentive for PTC to shift its business from IEX to PXIL or any other exchange. Fees for trading licensee are also regulated by CERC and exchanges have no role to play in it.
Another development here is the upcoming 3rd power exchange, which is actually promoted by PTC. But here as well, PTC will not have any big incentive because as per regulations, PTC cannot hold more than 5% in a power exchange. PTC in fact was also the promoter of IEX, it sold its stake in early 2018.
But risk of PTC is something that one should clearly track and keep in mind in case of IEX.
IGX- Another Optionality in IEX
IGX (Indian Gas Exchange) is a subsidiary of IEX, under which IEX has started a gas exchange for trading Natural Gas. IGX started operations in FY21. Natural gas is a big market in India and is expect to grow even bigger as government is targeting to increase Natural gas share in India’s total energy basket from current 6% to 15% by 2030.
Even currently, the opportunity for IGX is big; because unlike Power wherein the Short-term market is small at just 10% of total power, in case of natural gas, the spot market is already 25% of total gas market. And thus, there is a ready market for IGX.
However, compared to electricity wherein the key enablers for enabling free trade on an exchange platform is available; in case of natural gas, the market lacks few key enablers to make trading on exchange pick-up considerably.
In case of Power, there is a central system operator who takes care of entire scheduling of power through transmission lines. In case of Gas, there is no such central operator and transmission capacity for pipelines have to be booked separately.
India does not have a well-connected pipeline network.
Taxation of Natural Gas is a state subject and thus all states have different taxation policy for natural gas and thus buying/selling and pricing on exchange becomes cumbersome for different buyers/sellers in different states.
But government is pushing for enabling trading through exchanges. Finance ministry has announced that they are looking to bring natural gas into GST, this will result in uniform taxation. Government has also announced setting up a system operator for transmission pipelines. A new uniform tariff policy for transmission charges for pipeline use have also been announced.
IGX can turn out big for IEX because the gas exchange business can become as big as power exchange as soon as volumes pick-up. However, there is a catch here. As per regulations, IEX cannot hold more than 25% in IGX post the end of 5 years ie. 2025. IEX has already divested stakes to strategic partners like GAIL, Adani GAS, NSE etc and now holds 54% stake in IGX.
The upside here can come if volumes on the exchange gains traction in near-medium term and then IEX divest the remaining 30% stake towards the end of this 5-year period, unlocking good value for IEX.
So, this quite sums-up most of what is there to know about Power Exchange and IEX. IEX should benefit from growing power demand and incrementally capture a larger share of overall power market. There are few big Optionalities of MBED and IGX, but also keep in mind the risk factor of PTC.
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