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Sector update: Power Utilities - RoE spread over GSec likely to sustain in FY20 -24E

CERC is set to initiate discussions on regulatory norms for next 5-year tariff period (FY20-24). We have analyzed crucial parameters required to set the base return on equity (RoE), a key factor that has a bearing on the profitability and valuations of regulated entities. NTPC and Power Grid will be most impacted by these regulations within our coverage universe.

RoE spread on 10-year government securities (10-yr GSec): Apart from investments, we believe 10-yr GSec also plays a crucial role in arriving at the base RoE for the power sector, a key factor also cited by regulators. Average spread of RoE over GSec stood at 8.7% between Apr 2001 and Mar 2004, 6.7% between Apr 2004 and Mar 2009, 7.5% between Apr 2009 and Mar 2014 and 8.0% between April 2014 and Dec 2017. In March 2017, regulator has argued for 700bps spread over six month GSec for setting up base ROE  under renewable tariff regulations.

Base RoE remained rangebound between 14% and 16% over FY01-FY19:  CERC increased RoE to 16% for the tariff period FY01-FY04, which it has maintained, on the back of rising interest rates in 1998. Following a sharp decline in interest rates between FY01 and FY04, base RoE was brought down to 14% during the tariff period FY05-FY09, which was again increased to 15.5% during tariff regulations FY09-FY14 on rising interest rates. CERC has maintained 15.5% during the ongoing tariff period 2014-19.

Other factors apart from base RoE that impact earnings:  Earnings of generation, transmission and distribution companies are impacted by change in normative benchmarks set by regulators. In addition, change in regulations pertaining to optimal operations of assets, working capital and sharing of savings between consumers and asset owners can also have a bearing on companies’ earnings. We estimate 4-5% incremental return through optimal operations of power generation assets and 70bps to 100bps return for transmission assets. As a result, any significant deviation in the above parameters could hurt the return profile of generation and transmission projects. 

View and Valuation

We estimate base RoE will be fixed between: a) 15% and 15.5% in case 10-year GSec yield strengthens by 50 bps from the current Gsec yield of 7.3% b) 14% and 14.5% in case GSec yield reduces by 50 bps. We do not expect any meaningful decline in price to book ratio of regulated entities like NTPC and Power Grid on the back of inexpensive valuations, growth in capacity addition and likely spread of 700 bps between GSec and RoE. We thus reiterate our Outperformer rating on NTPC and Power Grid. Key risks to our call are: 1) tightening of other parameters equally crucial for overall return profile of power plants (incentives and savings) and transmission elements (normative parameters) and 2) complete change in methodology for compensating power assets (eg, Return on capital employed Approach).