Power Sector Analysis: Porters Five Forces Model

More than 63% of India’s total installed capacity is contributed by thermal power. Western region accounts for largest share (30.09%) of the installed power in India followed by Southern region with 27.76%. Unbalanced growth remains the cause of concern for the Indian power sector. Only about 56% of households have access to electricity, with the rural access being 44% and urban access about 82%. Southern region remains the dominant region in renewable energy source accounting for more than 57% of the total renewable energy installed capacity. India’s power generation has grown with nominal rate at 0.65% in 2008 compared with 3.90% increased in 2007. Thermal, hydro and nuclear and wind are the major sources of power generation. Thermal power generation recorded positive growth at 3.25% in December 2008 however hydro and nuclear were recorded negative growth rate at 12.41% and 21.62% respectively in December 2008 compared with December 2007. In April-December 2008 power generation were recorded 2.57% growth compared with April-December 2007. There has been significant improvement in the growth in actual generation over the last few years. As compared to annual growth rate of about 3.1% at the end of 9th Plan and initial years of 10th Plan, the growth in generation during 2006-07 and 2007-08 was of the order of 7.3% and 6.33% respectively.

Power Generation is primarily owned by the government (close to 90%) and the rest of the generation capacity is controlled by the private sector. Energy deficit in India has increased over the years. During the year 2007-2008, average energy shortage was 9.0 percent and peak energy shortage was 15.2 percent. As India develops, it is expected that energy demand will increase by more than 8 percent over the medium term. Factors that have been plaguing India’s power sector are capacity shortages, frequent power failures, poor reliability and deteriorating physical and financial conditions. Since majority of power generation is through thermal sources which are dependent on fossil fuels and cause environmental degradation through carbon emissions. Off late the government is laying more emphasis on using hydro and wind energy sources for power generation which are environment-friendly.

Break-up of Power Generation in India Mar’09

Source: Central Electricity Authority, BAS-ML Research

An analysis of the Power sector using Porter’s Five Forces model

Buyer Power

Based on the following parameters it can be said that Overall the buyer has weak power.

Low Switching Cost – switching cost for the buyers is low as of now but is supposed to increase when new players come in the market as the product in not differentiable i.e. electricity.

Buyer size – Very small.

Oligopoly Threat – Very Low.

Undifferentiated product – As the product i.e. electricity is undifferentiated product, so this increases buyer power.

Tendency to switch – Buyers will switch to the supplier who is efficient and cost effective.

Price sensitivity – Not much price sensitive

Financial muscle – Nothing as compared to PSEs.

Buyer independence – Low as of now but if more suppliers come into picture as Govt. has sought competition in this market, the buyer power will increase.

Product dispensability – Very Low.

Supplier Power

Based on the following parameters it can be assessed that the supplier Power in High.

Supplier size – Very Large as the suppliers are Large PSEs.

Oligopoly threat – Small number of suppliers enjoy monopoly, thereby contributing to the supplier power.

Switching costs – Very high, as only large govt. companies are the suppliers.

Player independence – Low

Substitute inputs – As no substitute inputs, so the firms have no choice.

Player dispensability – High

Differentiated input- Inputs are same i.e. electricity in case of company buying electricity from wholesale market and selling to the end-users, and coal or gas in case the company is in power generation field.

Threat of New Entrants

The Threat of new entrants is moderate based on the following parameters.

Low Switching Cost – Switching cost for the end-user is low, so it increases opportunity for the new entrants.

Undifferentiated product – Product is not differentiable i.e. electricity, so the users have the incentive to switch to the low cost supplier. This increases the opportunity for the new efficient entrants.

Fixed costs – High fixed cost acts as a barrier to entry for new entrants.

Little regulation – Delicensed generation and multiple licenses in the distribution in the same area of supply acts as an opportunity for the new entrants.

Distribution accessible – Increasing the threat of new entrants.

Suppliers accessible – Increasing the threat of new entrants.

Market growth – High, leading to great opportunities for new entrants.

Threat of Substitutes

The Threat of substitutes is Weak as per the following parameters.

Low Switching Cost – The cost of switching to substitutes like gas, solar penal, etc. is high.

Rivalry among existing firms

The rivalry among existing firms is low as per the following parameters.

Competitor size – Very Few companies very large in size like NTPC, NLC, NHPC, NPCIL, PGCIL etc.

Number of players – Very few.

Hard to exit

Ease of expansion – Difficult because of lack of investment and resources.

Why should weather derivatives be introduced in India?

Estimates suggest that the unutilized hydro power potential of India is in excess of 0.15 Million MW. This figure indicates that there is growing importance of weather dependent hydro and wind based power projects in India. Power generation through hydro and wind depends on a number of critical weather factors such as rainfall, snowfall, wind speed etc. Already weather derivative products based on these indices is being used in a number of countries. With the introduction of “availability based tariff” the spot market for electricity trading has come up where electricity is bought and sold by market participants like producers, consumers and intermediaries. These developments have taken the market for electricity closer to other normal markets in the economy where derivative trading has been successfully going on. Indian electricity market is still very much controlled by the government unlike the US market which is highly competitive. The Indian government offers a number of subsidies to the consumers thereby absorbing the cost of production and transmission and increasing the fiscal deficit. Introduction of weather derivatives will help in passing the cost to the consumer thereby reducing the burden on the government. Continuous supply of energy to agriculture and industrial sector is essential for the rapid growth of the economy. The government cannot afford to overlook this issue as this would act as a major deterrent to the foreign direct investment. Introduction of weather derivatives would bring in a lot of private participation in energy sector thereby making it more competitive, efficient and robust.

Introduction of weather derivatives would serve as an effective risk hedging mechanism for Indian power sector in comparison to other alternatives such as long-term power purchasing agreements.

Electricity Derivatives and long term power purchasing agreements:

All commodities are being successfully traded on Indian stock exchanges but derivatives trading in power sector has not begun yet. Weather derivatives would be traded soon once the parliament approves the amendment in Forward Contract Regulation Act. Although the electricity derivatives market have not done that well worldwide analysts suggest that unless the spot market for the underlying commodity is well functioning, it is very difficult to have a feasible derivatives market. It would be a difficult task to promote electricity derivatives in India as the spot market in electricity is still in its growing stage and private participation is almost nil.

Some of the requirements that should be met for a viable electricity derivative market:

An active and competitive spot market with a large number of private participants

Government should reduce its control over generation, transmission and distribution of power

Availability of adequate number of power exchanges that would cater to the need of each of the geographically segmented electricity market.

There should be sufficient surplus power generation capacity available so that power may be transmitted to desired destination without any loss of time.

The above features are nonexistent in the Indian market with the majority of the control lying with the government thereby making the electricity market in India highly non-competitive. As per reports it is suggested that in a non-competitive market demand for power should be met by long term power purchasing agreements and a very small percentage should be traded in the spot market because of price volatility. Such agreements hedge the risk of power producing companies but the risk is transferred to the purchasing companies who have to pay the contracted rates. Most of the state electricity boards in India are purchasing power through long term contracts and continue to be in a state of financial bankruptcy. This long term agreements simply shift the price risk to the consumer. In India as of now there are no power exchanges where electricity derivatives are being traded.

The above arguments indicate that risk hedging in Indian power sector through electricity derivatives and long term power purchasing agreements may not be a long term solution.

Weather Derivatives and their effectiveness for Indian Power sector

Weather derivatives are instruments used to hedge the weather dependent risk, which could be termed as financial gain or loss due to variability in daily climatic conditions. In the power sector the weather risk is huge both on demand and supply side as they are dependent on weather related factors. On the demand side the amount of energy required for both heating and cooling depends on the weather. Similarly on the supply side the hydro based power plants are dependent on annual rainfall and snowfall. If the rainfall is insufficient there would be less production and in that case the producers will have to buy from the costly spot markets to meet up the contractual obligation. This is highly risky and hence the hydro based power producers need a hedge against the weather risk. Variation in temperature, rainfall etc means that it would affect the power consumption. Indian electricity market is highly regulated with majority of control related to buying and selling of power is rested with the government therefore price risk in Indian context is not an issue but the volume risk is a major threat. Weather derivatives offer a feasible solution to overcome the volume related risk in Indian power sector as it can be implemented without disturbing the market structure or by making huge infrastructural investments. An essential requirement for trading weather derivatives is the availability of accurate historical and current weather data which is available at the Indian Meteorological Department. The financial market is well developed in India. One important requirement could be developing appropriate weather based indices, designing pricing mechanism for weather derivative contracts and educating the participants about the concept. Once regulatory roadblocks are cleared these contracts could be listed on major stock and commodity exchanges of the country where users, producers and other participants may trade them. State electricity boards and government owned power producers would benefit from weather derivatives. Trading in weather derivatives would also bring in a lot of foreign direct investment in power sector as this would be an effective way to hedge volume related risk in power sector. The government needs to open the power distribution to private players to bring in more liquidity and improve efficiency.

From above argument it is evident that the weather derivatives are a much better risk hedging alternative as compared to electricity derivatives and long term power purchasing contracts.

Selection of Appropriate Weather Derivative Contract

A suitable weather derivative contract depends upon the risk tolerance of buyer and the seller weather they are risk averse or risk loving and what their expectations are about the future.

Few basic rules before selecting a weather derivative contract:

If the parties are risk averse and wish to avoid paying contract premium then variable weather risk can be fixed with a swap contract.

If the parties are willing to take risk by paying a moderate to high premium and the probability of price hike is very high then a cap contract can be considered..

If the parties prefer protection from losses due to price decline or lower production more than the benefits from the price rise or increased production then a collar contract is the most suitable one.

Swap Contract

A weather swap can be constructed for a hypothetical power producer Hydel ltd. if it wants earnings stability from lower rainfall, but would also like to benefit from cold winter conditions without paying a premium.

Swap payout structure

Cap Contract

Assume that a power starves state electricity board wishes to hedge peak load requirement during the summer season. Further, it is assumed that past 20 years data reveals that during the five-month summer season there are 5,000 cumulative cooling degree days (CDDs), on average. After analyzing the relationship between power consumption and historical weather conditions, it is determined that for each CDD above 5,020, SEB’s earnings are affected by Rs. 50,000. Therefore, a weather cap contract is structured with a strike value of 5,020 and premium of Rs. 5 million.

Cap Contract payout structure

Collar Contract

Collar contract restricts the natural outcome to upper and lower put boundaries. It is a combination of put and call options. Consider the case of a hypothetical Counterparty Hydel Ltd. The possible payout profile would be:

Counterparty: Hydel Ltd.

Term: June 2005-May 2006.

Index: cumulative inches of rainfall per year, as measured at Station X.

Put strike: 40 inches (Hydel Ltd. receives below).

Call strike: 60 inches (Hydel Ltd. pays above).

Payment: Rs. 10,000 per 1/10 inch.

Put limit: 25 inches.

Call limit: 80 inches.

Premium: No premium.

Collar payout structure