I recently came across an article highlighting subdued M&A activity in the Indian solar space as it appears buyers are now reluctant to acquire older projects with high tariffs due to perceived curtailment and/or tariff revision risk! I guess this means the latest solar tariffs may not be so irrational after all.
A high tariff is only as good as the offtaker — and keep in mind that attractive legacy tariffs are principally the domain of state Discoms as central offtake came into the picture only recently. On the flip side, while tariffs may now be eye poppingly low for central offtakers like NTPC or SECI, they come with the comfort that the resulting top line is being implicitly underwritten by GOI. It is in this backdrop that I don’t completely “get” the concerns that solar projects are unviable at recently discovered low tariff levels.
IRRs May Appear Low in Absolute Terms, But They Are Not in Negative Territory
First, while resulting Internal Rate of Return to Equity (IRR— and I don’t agree with this single narrow measure as being the last word in investment decision making) gives the appearance of being low in absolute terms, it is still solidly positive — so it is not as if absolute returns have drifted even close to negative territory. Second, once a decision to invest has been made, energy sector project viability in general remains threatened by a host of factors such as cost overruns, constraints on availability of input, sudden increases in price of input and curtailment of offtake. All of these risks have tended to afflict traditional sources of energy generation in India, more so the recent additions to capacity contracted with various state Discoms for offtake. Solar on the other hand is either inherently immune to these risks or is implicitly covered on the curtailment front by central offtake.
An IRR Only Investment Making Process Can Lead to Value Destruction If Not Balanced with an Independent Assessment of Project Risk and Resulting Required Capital Cost
This brings me back to my earlier point on IRR. Using an ad hoc target IRR derived from some perceived sponsor cost of capital, or even worse, a single ad hoc target IRR for different project types as a one size fits all approach to hurdle rates, is fraught with danger. A sound investment decision is one where IRR exceeds a project’s independently calculated cost of equity (CoE), for only then will it turn out value accretive, otherwise we are talking value destruction. It’s important not to confuse the investor/sponsor cost of capital with the project CoE here. It’s even more important to ascertain the project’s standalone CoE reflecting all risks in the first place.
India today has thousands of MW of stranded thermal capacity. In many instances investment decisions appear to have been made on the basis of financial models that simply churned out IRRs that exceeded perceived sponsor cost of capital. A correct approach, which calculated a distinct CoE for each project reflecting 360 degree risks for the same, would have most likely revealed a CoE in excess of financial model derived IRR, sending a clear signal to sidestep the opportunity. In other words, project risks were greatly underestimated and not adequately captured in the hurdle rate when assessing projected cash flows. Instead, an erroneously lower hurdle rate encouraged unnecessary risk taking.
With Thermal, Risks Were Underestimated; With Solar, an Overestimation of Risks Appears to Be Taking Place
With solar, it appears the prevailing belief that tariffs are too low flows from the opposite direction, i.e., an overestimation of risk. Among other features, solar projects benefit from insignificant cost overrun risk in light of ever falling module prices, zero input cost, zero input cost volatility, minimal O&M risk and generation contracted out with an implicit GOI guarantee — so where is the risk? Adding minimal barriers to entry into the mix merely helps to explain the rapid pace of drop in tariffs towards a natural floor but not the level of the natural floor itself.
Returns Expectations for Solar Need to Be De-linked from Thermal and Approached from a Totally Different Perspective
This brings us to the most topical question of all — where exactly does this natural floor lie? To truly understand solar is to appreciate its simplicity and to discard all the baggage accumulated over years of analyzing the economics of traditional, more risk prone sources of energy generation. In this light, the natural floor for solar tariffs in India cannot be discerned by starting at the top and chipping away at a thermal derived returns (with its corresponding tariff) benchmark.
On the contrary it can only be appreciated by working one’s way from ground up. This means identifying an appropriate market determined returns reference benchmark for what solar’s underlying cash flows really represent, and then asking oneself how much additional return one requires beyond that benchmark for the trouble of simply waking up every day and waiting for the sun to shine. An honest answer to this fundamental question will point to required returns and corresponding tariff, and if one is not happy with those numbers, one can be sure that there are many others who will be.
This article was originally published by the author on LinkedIn and was republished with permission.