In the concluding part of the hypothetical case study of three privately financed power projects, Bob Nelson investigates the regulatory hurdles that infrastructure investors must clear before construction can begin
Last month, India Business Law Journal introduced Windways, a fictional power company seeking to invest in India’s emerging infrastructure sector. Windways is considering three prospective investments, collectively known as Project Windstorm: The first is a 240 MW wind farm in a state with a reasonably cooperative electricity board and well-developed regulations. The second is a 12 MW photovoltaic solar power plant combined with a 200 MW gas-fired power station and small wind farm, all located in a “green” special economic zone (SEZ) being developed by an Indo-foreign joint venture.
The company’s third prospective project is a distributed rural electricity scheme using a combination of small-scale wind, solar, and biomass resources.
As Windways moves forward to the difficult task of evaluating the regulatory issues associated with each potential investment, it has benefited immensely from the advice of prominent lawyers and law firms who volunteered their feedback following the discussion of the company’s plight in the February issue of this magazine. Of particular note were comments received from Amit Kumar, Sunando Mukherjee, Varun Sehgal and Shardul Shroff of Amarchand Mangaldas; Upendra Joshi and Rabindra Jhunjhunwala of Khaitan & Co; Anand Desai of DSK Legal; and Snehal Patil of Thelen Reid.
Structuring for success
Windways had been planning to structure its investments through special purpose subsidiaries based in Mauritius, but it was also considering other offshore alternatives such as Cyprus. However, lawyers from Khaitan & Co have cautioned that the India-Cyprus double tax avoidance treaty is being renegotiated, and that the benefit of capital gains tax exemption could be lost. As a result, Windways feels comfortable in its decision to take the well-trodden path through Mauritius.
Furthermore, Amarchand Mangaldas has given Windways the good news that it may be permitted to establish a foreign entity in India, either a project office under the Foreign Exchange Management Act, 1999, or an Indian project company which would be formed under the Indian Companies Act, 1956.
For each of the proposed projects, foreign direct investment is permissible under the automatic route, and since 100% foreign investment is allowed in power generation, there is no legal need for Windways to team up with an Indian partner.
In spite of this, for a number of practical reasons Windways is considering taking on a local partner, particularly for the first and third of its prospective projects.
If chosen well, an Indian partner may have extensive experience in working with the relevant government authorities. It may also have good relationships with key people involved, and a good tactical understanding of how the regulatory landscape can best be navigated.
To the extent that there may be the potential of government subsidies on the renewable energy front, having a local partner with strong contacts with the relevant officials could also be very helpful.
The same reasoning also applies to Windways’ second project, but here the company already has the option of working with the Indian co-developer of the SEZ.
A critical factor in the success of the Windstorm projects will be the company’s access to suitable land. Having a local partner may also help in this regard.
As Mumbai-based DSK Legal explains, Indian partners may already have the land rights that would be required for the power facilities. This would obviously be a major boost for Windways, particularly in relation to the large wind farm contemplated in the company’s first project. However, it would be less crucial for the company’s second project because the SEZ would have acquired the relevant land already, or for the distributed rural generation project, for which the land requirements would be less extensive and less concentrated.
Nonetheless, given the level of activity in the Indian real estate sector, and the recent appreciation in land prices, a local partner with significant land rights in a good location, possibly combined with a proven track record of land acquisitions, would be an extremely valuable asset.
For the development of its proposed 240 MW wind farm, Windways is also considering a partnership with an Indian manufacturer of wind turbines. It has a suitable partner in mind that may be willing to take some equity in the project in partial payment for the turbines. Windways therefore needs to weigh the potential benefits of this option against the benefits of acquiring foreign-manufactured wind turbines that could be financed, in part, through favourable interest rates available from export credit agencies.
Despite recent efforts by India’s finance minister, P Chidambaram, to “jaw down” interest rates in India, the cost of domestic borrowing is still comparatively high. The ability to leverage project returns through reasonably priced foreign borrowings could therefore be helpful to Windways, but the company must bear in mind that there might be issues involved in bringing foreign equipment into India for the project.
SEZ permits innovative structure
For its SEZ-based project, Windways had been considering a partnership with the Indo-foreign developer of the special economic zone. But Amarchand Mangaldas has informed Windways’ managers that an alternative structure could involve the formation of a special wholly owned subsidiary which would enter into an agreement with the developer of the SEZ. The legal team at Amarchand Mangaldas has also pointed out that by virtue of the definition of a “co-developer” in section 3(12) of the Special Economic Zones Act, 2005 (the SEZ act), read in conjunction with section 3(11) of the same act, the subsidiary would be eligible for various incentives.
If it proceeds along this route, Windways will be required under the Electricity Act to divest a minimum of 26% of its stake in the subsidiary to the Association of Units in the SEZ, who would then procure at least 51% of the power produced.
Sizing up the hurdles
When evaluating its three prospective investments, Windways was keen to determine whether the regulatory hurdles facing each project were similar. Its managers were pleased to learn that none of the projects would require approval under the Electricity Act, 2003, due to the deregulation that has already been introduced in most power generation sectors. But that is not to say that Windways has blue skies ahead: there are still a number of significant regulatory issues with which the company must contend.
In many respects, Windways’ first project (the 240 MW wind farm) may be the most straightforward, subject, of course, to the regulatory regime and the attitude of the state in which it is to be located. Many of the issues that typically hinder thermal power plants do not apply to wind projects, for which significantly fewer environmental questions tend to be raised. Nevertheless, Windways will be required to submit an environmental impact assessment and follow a regulatory process that may become complex and lengthy, especially if the relevant authorities are busy.
Furthermore, despite government initiatives to combat the practice, corruption remains a serious problem, particularly at local levels. Windways must be prepared, therefore, to deal with subtle – or even not-so-subtle – requests for improper payments if they should arise.
The number of levels of government that need to be involved in the regulatory approval process varies from state to state. In Himachal Pradesh, for example, the village-level government body (“gram panchayat” or “gram sabha”) is responsible for clearing projects prior to their construction. It is therefore important for Windways to nurture good relationships with these authorities, as well as with the communities in whose hinterlands its projects are to be located.
Acting in the public interest
Another reason for cultivating local acceptance relates to possible opposition by private or NGO-based organizations. This opposition can play out not only through the political process, but also through the courts. Disaffected individuals and groups may file public interest litigations, and as DSK Legal warns, these actions can be based on a wide range of perceived impacts, ranging from the project’s effect on agriculture, forest land and the environment, to the negative impact of construction, roads and increased traffic.
Public interest litigations can severely delay the permitting process. They can also impede the financing of the project, even if the relevant permits have already been issued. Furthermore, public interest litigations have the potential to absorb a great deal of management time.
Windways’ second proposal (power generation facilities in a SEZ) faces very different regulatory requirements. As Amarchand Mangaldas explains, the approval process for this project will be simplified on account of it being located in a special economic zone.
Under the SEZ act, state governments are obliged to consider whether a SEZ has made adequate power generation, transmission and distribution arrangements before approving its application, and this clearly makes Windways’ proposal attractive to SEZ developers. However, Khaitan & Co cautions that the broad definition of “infrastructure facilities” in the SEZ act leaves room for conflict between this and the Electricity Act with respect to whether power generation facilities within a SEZ require specific approval. Careful reading would appear to suggest that the Electricity Act prevails, and that no such approval is needed. However, Windways is now aware of the ambiguity and will tread with caution as a result.
The permit framework for privately funded generation facilities in SEZs depends, in part, on how good a job the SEZ developers have done in obtaining general permits and approvals for their special economic zones. Windways must investigate this thoroughly before reaching an investment decision. It is particularly important in light of the fractious nature of SEZ legislation at national and state levels, as well as the history of public interest litigations in which local residents, and NGOs working on their behalf, have challenged the rehabilitation and relocation packages that have been offered by SEZ developers.
Most of these litigations have related to land acquisition for SEZs, particularly the compulsory acquisition of agricultural land. DSK Legal emphasizes the importance of this consideration, and warns that recent protests in villages in Goa led to the state government scrapping as many as 12 SEZ projects there.
Windways, however, has done its homework and is confident that the “green” SEZ in which it hopes to base its power generation facilities has successfully avoided these difficulties. Furthermore, if the SEZ itself has already submitted an environmental application that made provision for the construction and installation of the energy facilities in question, Windways can look forward to an expedited path to obtaining the necessary project permissions.
There are, however, some more complex issues that could emerge relating to the nature of the SEZ and the potential for excess power to be exported from the SEZ to surrounding businesses or power utilities.
The SEZ act contemplates power generation sources in SEZs being primarily for the use of customers within the SEZ. It does make some provisions for the sale of surplus electricity to external customers, but Khaitan & Co warns that the sale of excess power will require a number of different approvals from various authorities, as well as an application for open access to the transmission grid.
Amarchand Mangaldas notes that duties may also be payable on fuel and consumables used in connection with the power distribution (this would obviously be more of an issue for the gas-fired power plant than it would for the wind or solar generation facilities). It is therefore important for Windways to consider how much of the power will be sold to customers within the special economic zone, in order to evaluate the economics of the proposed facilities pending the completion of the approval process for sales to external customers.
And the considerations don’t stop there. In order for Windways to be confident about the “quality” of revenue it can expect from the project, it has to assess the payment capacity of its target clients. Inside the SEZ, it would clearly be impossible to assess the creditworthiness of every potential customer. It is important however, to assess the creditworthiness of the SEZ developer, and if possible to sell the electricity through the developer, subject to a minimum guarantee.
For sales made outside the SEZ, both Amarchand Mangaldas and Khaitan & Co warn that Windways will not be at liberty to set its own price. Tariffs will be subject to the approval of the state electricity commission, pursuant to the Electricity Act, unless the tariff has been arrived at through a competitive bidding process.
Windways could potentially obviate some of these approvals and restrictions by selling power directly to specific customers outside the SEZ. However, this raises the same fundamental risk that applies to sales within the SEZ, namely, creditworthiness. Furthermore, when power is transported in India, there is always the issue of transmission and distribution losses – or, as they are colloquially known, losses due to “theft and dacoitry”.
Indeed, even if Windways jumps through all the regulatory hoops and manages to sell its power to the grid, it will still have serious credit risks stemming from the parlous finances of many state electricity boards. It will therefore be wise to adopt credit support mechanisms such as obtaining letters of credit from its primary private and government customers. There may be some difficulties, however, in obtaining these from government organizations, particularly since electricity from renewable sources is often more expensive than that produced from fossil fuels.
The satisfactory resolution of these credit issues is critical for Windways, not least because it will need to convince its own debt and equity investors that the prospective returns and debt service coverage ratios are attractive.
In search of subsidies
Such financial concerns beg the question of whether Windways would be entitled to any domestic or foreign subsidies to boost its bottom line. This would be unlikely for the thermal power plant that forms the cornerstone of the company’s SEZ project. However, its third prospective investment, which involves the rural distribution of power from wind, solar, and biomass resources, may qualify.
Amarchand Mangaldas observes that certain subsidies and fiscal incentives are available at both the central and state government levels. These subsidies are typically low, but when it comes to truly innovative technologies, such as some of the distributed biomass generation technology that Windways has developed, there may be the opportunity to acquire higher levels of funding.
The Indian Renewable Energy Development Agency is a potential source of loans with concessionary rates of interest, and public-sector and development banks may also offer special financing.
However, the interaction between special subsidy programmes and applicable tax laws may create difficulties. For example, the Ministry for New and Renewable Energy (MNRE) offers incentives to certain solar generation facilities. However, if the developer is seeking accelerated depreciation benefits under section 32 of the Indian Income Tax Act, 1961, it cannot simultaneously avail itself of these MNRE incentives.
There are, of course, international sources of funding as well. Depending on the nature of the project, there may be soft loans or grants available from multilateral development institutions such as the World Bank and the Asian Development Bank. The distributed generation project is a natural candidate for these: It offers the benefits of poverty reduction, by bringing power at affordable prices to areas that desperately need it; heathcare, through associated programmes of water purification and the provision of a stable source of power for local medical facilities; and education, through the distribution of power to schools and electronic educational tools such as computers.
For Windways’ other two projects, certain funds might be available from multilateral institutions like the International Finance Corporation that have more of a private sector orientation. The SEZ project may be particularly attractive because the special economic zone in which it is to be located is a designated “green” zone, an important consideration in a country where explosive economic growth threatens to have an equally explosive impact on the local and global environment.
Following its strategic analysis of the three prospective projects (discussed in the February issue of India Business Law Journal), Windways has now conducted a much more thorough assessment of the regulatory issues, threats and opportunities that may affect each proposal. It has also taken on board the expert advice and opinions it received from prominent Indian law firms.
On the basis of this analysis, the directors of Windways have decided to pursue all three projects as part of an integrated and coordinated effort to take part in energy and infrastructure development in India.
Each of the projects has a different risk-and-reward profile and a different timeline. However, they also have much in common, including the risk of being enmeshed in regulatory issues, customer creditworthiness issues and the lack of availability of credit support.
Nevertheless, Windways is satisfied that it has undertaken careful analysis of the potential issues and it has decided to work with Indian partners in different ways on each project. While it recognizes that the development path will not necessarily be smooth, like many other investors in India’s burgeoning infrastructure sector, it is committed to moving forward.
Bob Nelson is a partner at Thelen Reid Brown Raysman & Steiner. He can be contacted at [email protected] Bob would like to acknowledge the assistance of the following people in the compilation of this case study: Amit Kumar, Sunando Mukherjee, Varun Sehgal and Shardul Shroff of Amarchand Mangaldas; Upendra Joshi and Rabindra Jhunjhunwala of Khaitan & Co; Anand Desai of DSK Legal; and Snehal Patil of Thelen Reid.