Bidding for CGD Licences: Need to tread with caution?

Need to tread with caution?

Ever since the incorporation of the Petroleum and Natural Gas Regulatory Board (PNGRB) in 2006, city gas distribution (CGD) licences for new cities/geographical areas (GAs) have been issued based on the bidding route, with the regulations for bidding governed by the PNGRB (Authorizing Entities to Lay, Build, Operate or Expand City or Local Natural Gas Distribution Networks) Regulations, 2008 and their various amendments. Under these regulations, six bidding rounds have been concluded, with results having been announced till Round 5 for 32 GAs. The regulator has simultaneously invited bids from interested parties for setting up CGD networks in 11 cities covered under the Smart Cities project.

An analysis of the bids received in the first six rounds presents a contrasting picture. The first two rounds saw elevated competition, with a few players quoting near-zero network tariff and compression charges, and aggressive targets for piped natural gas (PNG) connections and steel pipeline laying. This prompted the PNGRB to make certain amendments to the bid guidelines so that irrational bids could be discouraged. For the third round, a feasibility report (FR) was stipulated and there was a condition that variation between the figures in the FR and the actual figures quoted could not be more than +/-20 per cent. Despite these changes, several bids continued to be aggressive (with underlying assumptions such as low capex/opex, high gas demand per inch km of pipelines, domestic connections, etc.). In order to ensure rational bids, the regulator made further changes in the bidding selection criteria, which included dispensing with the FR and modified limits on annual variation of the network tariff and compression charges, from Round 4 onwards. Additionally, a minimum work programme (MWP) for domestic PNG connections and inch km of steel pipelines to be laid by the successful bidder was introduced, instead of these being bid variables as in the previous rounds. The rationale for this substitution was to ensure adequate coverage so that the benefits of gas supply could reach the largest number of people. In case of a tie in the bid tariff, the company that quoted the highest bid bond/performance bank guarantee would be declared the winner.

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Recent bidding rounds indicate that certain GAs, such as Rae Bareli, Amethi, Chitradurga and Nainital, did not receive even a single bid, while others saw elevated competition. In general, competition has been high in GAs perceived to have high business potential, such as Bengaluru, Ernakulam, Amritsar and Panipat, a thriving economy backed by a high vehicle population, a large number of domestic households, and a strong industrial and commercial customer base.

While GAs with no bids give comfort to investors that bidders are considering all possible business and financial risks before committing bids and shying away from GAs found to be unviable, bidding at extremely low rates of network and compression charges for a few high potential GAs is a cause for concern. Each of the bid winners in the nine GAs which have been granted authorisation in the fourth round have bid at the lowest possible network and compression charges of Re 0.01 per million British thermal units (mmBtu) and Re 0.01 per kg respectively for all 25 years of network exclusivity.

Discussions with the industry stakeholders indicate that bid winners have taken a calculated risk that they will be able to justify the high difference between compressed natural gas (CNG) and PNG prices, which will be market determined, and the network tariff/compression charges quoted which are at near-zero level, as the  marketing margin. It may be noted that the latter as well as the market prices are not within the jurisdiction of the PNGRB.

Moreover, the assumption made by bidders was that there would be limited or no competition from third-party marketers, as open access regulations are riddled with several grey areas, which will effectively stifle competition. A few other bidders are believed to have relied on the potential for future mergers and acquisitions with the operators of contiguous GAs  while placing their bids. On the whole, whilst these assumptions may be true in today’s scenario, most of the loopholes could get addressed during the economic life of the licence (25 years) through an amendment in the PNGRB’s regulations, as the regulator’s mandate is to foster competition and fair trade. In such an eventuality, aggressive bidders could be exposed to the following risks.

Competition from third-party marketers: The bid winners will be exposed to higher business risks once the marketing exclusivity expires after the first five years (which is effectively only two-three years due to the network set-up gestation period of two-three years). From the sixth year onwards, third-party marketers could take advantage of the abysmally low network tariff to supply gas through the existing network. Typically, CGD operators are required to incur large capex in the initial five years of operations, when they have marketing exclusivity, to set up the pipeline network and CNG stations. This is estimated to be in the range of Rs 4 billion-Rs 5 billion per GA, to reach volumes of 0.5 million standard cubic metres per day. On account of high capital intensity, profitability is highly dependent on the ability of companies to scale up operations and maintain a good contribution margin in the midst of volatility in gas sourcing costs, forex rates and alternative liquid fuel prices. Industry-wide gross contribution margins range from Rs 5 to Rs 10 per standard cubic metre (scm) of gas, and this allows CGD operators to adequately cover the high network maintenance and fixed costs (including interest and depreciation), besides the equity returns. Thus, if a third-party marketer were to use the network, first, it is quite likely that this would displace some of the existing consumers of the CGD operator; second, the marketing margin, which allows the CGD operator to generate optimal returns today, would not be available. Only the regulated minimal (based on bid values) network and compression charges would be payable to the CGD operator. Thus, the low network tariff and compression charges bid will affect the CGD bid winners adversely. ICRA believes that the possibility of losing bulk consumers such as state transport corporations and industrial customers could be more than that of losing retail consumers in such a situation due to the ease of entering into bilateral gas supply agreements; hence CGD operators with high concentration in the PNG (industrial) segment may be relatively more at risk of losing volumes to third-party marketers. While competition may not materialise immediately after the exclusivity period is over because of the likely persistence of the domestic gas deficit, it could be a threat over the longer term when the domestic gas supply scenario improves and clarity emerges on the domestic gas allocation for third-party marketers.

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ICRA also notes that the Ministry of Petroleum and Natural Gas has been exploring the possibility of allowing the marketing of CNG independent of the CGD network, which will enable companies with marketing licences to retail auto fuels (such as Reliance Industries Limited, Essar Oil and Shell, besides PSU oil marketing companies) to take up CNG marketing as well. This is contained in the Graft Guidelines for Granting Marketing Rights for CNG as a Transportation Fuel, Including Setting up of CNG Stations, dated March 5, 2015. While the final guidelines are awaited, a near-zero network/ compression tariff could be an open invitation to competition for the recent bid winners.

Encashment of bank guarantees: Further, in case of a tie in the tariff bid, the winner is selected on the basis of the value of the bid bond submitted. After the company which submits the highest bid bond wins, as per the guidelines it has to submit a performance guarantee valid for five years and equivalent to four times the value of the bid bond (which has to be renewed every five years till the end of the authorisation period). As a result of the higher competition in some GAs, the performance guarantees required to be submitted in the case of Round 4 winners is significantly higher than in the earlier rounds.

Also, the PNGRB prescribes the annual MWP for the bid winners to be achieved in terms of steel pipeline length and PNG (domestic) connections to be set up in each of the first five years. The PNGRB may consider carry forward of the annual target from one year to the next within the period of five years, if the delay in implementation is on account of valid reasons. Moreover, CGD companies are expected to meet certain minimum service standards while dealing with their customers. ICRA believes that although the PNGRB gets a stronger commitment from bid winners to set up operations in a GA by way of the high performance guarantee submitted, the same expose bid winners to a significant contingent liability in case of any delay/default on the MWP and inability to meet service standards. In the worst-case scenario of the guarantees being fully or partially encashed for non-fulfilment of the MWP and/or service standards, the same amount would in effect add to the project cost for setting up the network in a particular GA, which could affect the project’s viability.

In this context, it may be worthwhile to draw lessons from other infrastructure sectors where bidding practices are prevalent. Experience from the thermal power, solar power, road, port and telecom sectors, where aggressive bidding has taken place, has been unsatisfactory, with the concerned entities experiencing significant stress on their cash flows when their aggressive pre-bid assumptions went awry, leaving in their wake non-performing assets for lenders and a sharp fall in equity returns. The risks are high for CGD consumers as well, through possible disruption in services if non-serious players experience financial distress and are unable to continue operations.

Hence, even while the CGD sector presents significant growth opportunities through future bidding rounds, it will be prudent for CGD players to put in realistic bids to mitigate the several imponderables which they will face during the licence period.

k-ravichandran-svp-icraRavichandran, Senior Vice-President and Co-Head, Corporate Ratings, ICRA