l Equity Research l

India I Basic Resources

27 September 2013

India coal
Coal block auctions: A game changer
hide column-old Mkt cap rating Price (USD mn) (lc) 29,902.9 297.00 PT (lc) 341.00 Up/(Dn) side (%) 14.8 PER (x) FY1E FY2E 10.8 11.5 EV/EBITDA (x) FY1E FY2E 6.2 6.2 Div yield (%) FY1E FY2E 4.7 4.7

Coal India

Ticker COAL IN

Rec OP

Share prices as of 25 September 2013 Source: Companies, FactSet, Standard Chartered Research estimates

The Union Cabinet of India has approved the auction of coal blocks to private companies. We believe this can significantly improve coal availability in India in the next four to five years. The development is positive for power equipment manufacturers, as increased availability of coal will spur demand for power equipment. Our scenario analysis using broad contours of guidelines indicates that power producers could realise a healthy RoE of c.23%, even if they bid at twice the base price. We maintain our Outperform rating on Coal India and BHEL (BHEL IN, OP, PT INR 182).

Government move to auction coal blocks is a positive step

The Union Cabinet of India has approved the auction of coal blocks to private companies. If implemented properly, this can significantly alleviate coal supply issues four to five years from now. The current domestic coal demand/supply environment indicates that until FY17, India will continue to import significant quantities of thermal coal, at c.170mn tonnes from 120mn tonnes in FY14. However, after FY17, the supply-side bottlenecks should ease considerably, given Coal Indias initiative and the auction of coal blocks. According to the guidelines, the Ministry of Environment and Forest (MoEF) will be involved in the auction process. Hence, regulatory issues should not lead to significant delays in the projects, in our view. In addition, there are other safeguard measures that ensure that mine developers commit to minimum project development requirements and adhere to the defined timeline. We believe this development will initiate a new investment/capex cycle in the power sector. Although there is significant demand for power, coal supply issues were preventing new players from entering the market. This policy initiative should encourage potential new entrants. Our scenario analysis, using broad guidelines, indicates that power producers could realise a healthy RoE of c.23%, even if they bid at twice the base price. Such profitability is sufficient to spur investments, in our view. Other industries such as cement/aluminium also gain, as they get an assured supply of coal at lower rates.

Satish Kumar
Satish.Kumar2@sc.com +91 22 4205 5906

Saurabh Prasad
Saurabh.Prasad@sc.com +91 22 4205 5907

Jay Kakkad
Jay.Kakkad@sc.com +91 22 4205 5932

Important disclosures can be found in the Disclosures Appendix

All rights reserved. Standard Chartered Bank 2013 http://research.standardchartered.com

Equity Research l India coal

Coal block auctions: A game changer

Our analysis shows that coal block auctions can be a significant game changer for coal availability in the country. If properly implemented, these can significantly alleviate the coal supply concerns in the country in the next four to five years. We believe that relatively clean blocks will be put up for auction, which should reduce the time taken for regulatory approvals significantly. Hence, under normal circumstances, coal blocks can become operational within five years from the date of auction. According to media reports (The Hindu Business Line, 23 September 2013), four coal blocks with estimated reserves of 2bn tonnes will be up for auction in the next two to three months.

Coal block auctions: The methology

The Government of India has approved the methodology for the auction of coal blocks. On a broader level: 1. The base price will depend on international prices. However, power developers will get a 90% discount on the base price. There are adequate safeguard mechanisms to ensure developers commitment. MOEF clearenece does not apear to be a big hurdle in the auction regime.

2. 3.

The base prices will depend on international prices The base auction price of the coal blocks will depend on international coal prices. However, there are sufficient concessions for power developers provided they follow the defined norms of the auction. The methodology provides for production-linked payment on an INR/tonne basis and a basic upfront payment of 10% of the intrinsic value of the coal block. The intrinsic value of the coal blocks will be calculated on the basis of net present value (NPV) of the block, calculated through the discounted cash flow (DCF) method. To benchmark the selling price of coal, the international FOB price from public indices such as Argus/Platts will be used by adjusting it by 15% to provide for inland transport cost. This would help arrive at the mine-mouth price. In order to avoid short-term volatility, the average sale price will be calculated using prices during the past five years. Regulated power developers will get a 90% discount on the intrinsic value for tariffbased bidding. This methodology will help rationalise the power tariff. There are safeguard mechanisms to ensure developers commitment Past experiences with coal block developers have not been encouraging due to their failure to develop the projects. Hence, the government has incorporated the following safeguards in the auction guidelines: There will be an agreement between the Ministry and the bidder to perform minimum-work programmes at all stages. There will also be development stage obligations in terms of milestones to be achieved such as obtaining the mining lease, environment/forest clearances etc. The bidder will have to provide a performance guarantee during the developmental stage. The successful bidder will get two years for exploration (for regionally upgraded blocks) and five years for the development of coal blocks.

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Equity Research l India coal

The new policy also provides for relinquishment of the block without a penalty, provided the bidder has carried out the minimum-work programme stipulated in the agreement. MOEF clearance does not apear to be a big hurdle in the auction regime MOEF clearances have been the key impediment for the majority of coal block development in the past. In the present guidelines, the following safeguard measures have been included to ensure that MOEF clearances do not become a big hurdle. While the final MOEF approval will be subject to the statutory clearances under the law, the MOEF will review the details of the coal blocks and communicate its findings before the blocks are auctioned. Exploration activity in identified coal blocks are at advanced stage and are likely to be completed shortly. Thereafter, these blocks would be auctioned under the Competitive Bidding of the Coal Mines Rules, 2012, notified on 2 February 2012.

Coal block auctions: Good for power equipment demand

In our note published on 19 June, 2013, India capital goods: Myths and realities of power equipment demand, we had argued that in the 13th plan, India needs at least 75GW of power capacity addition. While power demand is not a concern, the primary worry is coal availability for the new power plants. The recent cabinet approval to auction coal blocks is a positive for the power equipment manufacturers, as increased availability of coal will spur demand for power equipment. Coal India has been unable to ramp up production in the past As discussed in our SCout report dated 4 March 2012, India coal: facing a supply crisis, Coal India has been unable to ramp up production in the past couple of years. In FY13, the company produced only 452mn tonnes against its target of 465mn tonnes. Furthermore, we believe Coal India is likely to miss its production target of 482mn tonnes in FY14. Still, coal import requirements may not rise as fast as feared While Coal India has been unable to ramp up production, coal demand has been rising. With the presidential directive to sign the fuel supply agreements (FSA), Coal Indias commitment to supply coal to power plants is increasing while its production growth is not in tandem. However, the recent developments led to a slower-thanexpected rise in steam coal import requirements. Much of the power capacity that has been commissioned since FY10 is not running at the desired capacity utilisation. Coal India has been signing FSAs with power plants only in the past few weeks. Even though there is significant demand for power, plants using imported coal are not able to sell power at competitive rates. Hence, the utilisation rate is lower than the desired level. Much of the power capacity gets commissioned towards the latter half of the year. Since it takes a minimum of six months for power plants to stabilise operations, we have assumed incremental coal demand from next year. Our demand forecasts take into account the coal requirement for the abovementioned constraints. We also estimate that Coal India will not be able to achieve its production guidance of 615mn tonnes by FY17. However, as discussed in our report published on 28 August 2013, Coal India: Its not all gloom and doom, Coal India has a huge number of projects in the pipeline and hence could surprise positively.
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Equity Research l India coal

Figure 1: Indian steam coal import requirement may not rise as fast as expected
(mn tonnes) Coking coal Non coking coal demand - Power (utilities) - Power (captive) - Cement - Sponge iron - Others Total non coking coal Total coal Demand Coal supply Coal India Limited (CIL) Singareni Collieries Company Limited (SCCL) Captive and others Total coal production Coal import requirement Coking coal Non coking coal Coke and others Total imports
Source: Ministry of Coal, Standard Chartered Research

FY09 37.7 363.3 34.1 20.1 19.8 76.7 514.0 551.6 403.7 44.5 44.5 492.8 21.1 37.9 1.9 60.9

FY10 41.1 379.0 39.2 21.4 23.1 86.2 548.9 590.0 431.3 50.4 50.4 532.0 24.7 48.6 2.4 75.6

FY11 43.9 389.6 40.8 25.2 23.1 93.6 572.2 616.1 431.3 51.3 50.0 532.7 19.5 49.4 1.5 70.4

FY12 46.1 436.0 36.9 13.5 21.3 81.1 588.8 634.9 435.8 52.2 51.9 539.9 31.8 71.0 2.4 105.2

FY13 48.6 479.6 38.4 28.5 18.2 85.2 649.8 698.5 465.0 53.1 57.8 575.9 32.2 97.2 6.0 135.4

FY14E 51.5 527.6 40.0 29.9 19.3 89.4 706.2 757.7 491.0 54.0 57.8 602.8 35.5 119.4 154.9

FY15E 55.7 576.0 40.0 32.3 20.8 93.9 763.0 818.7 504.0 54.0 62.4 620.4 39.6 158.7 198.3

FY16E 60.1 626.7 40.0 34.9 22.5 98.6 822.7 882.8 545.0 55.0 67.4 667.4 44.1 171.3 215.4

FY17E 64.9 677.4 40.0 37.7 24.3 103.5 882.9 947.8 599.0 55.0 74.2 728.2 48.9 170.8 219.7

Auctioned coal block will add to the supply pool According to Coal India management, it is working on the projects that can yield around 486mn tonnes of coal. Compared with Coal Indias guidance of 135mtpa of incremental coal, our demand-supply model assumes c.120mtpa of incremental coal from ongoing/new projects by FY17. The auctioned coal blocks will add to this pool of new supply. India plans to auction around 2bn tonnes of coal reserves by December 2013, and incremental production could reach 50mtpa after the coal blocks are fully developed. Given that the government will mitigate procedural/statutory bottlenecks for the auction (MoEFs in-principle clearance, undisputed land, among others), it is likely that these coal blocks will be able to produce coal in the next four to five years. In fact, Jindal Steel and Power (JSPL IN, NR) said on CNBC TV-18 that it can develop open-cast mines in 6-12 months. Incremental coal production of 50-60mn tonnes beyond FY17 is possible We believe India can incrementally produce 50-60mtpa beyond FY17, given Coal Indias project pipeline and the coal block auctions.

Economic sense for power producers to bid even at twice the base price
Our analysis indicates that buying coal blocks in auctions makes perfect economic sense for power developers. Captive coal blocks should take care of various aspects like vagaries of Coal India supply, volatility in international coal prices, unavailability of port infrastructure to import and the lack of a transportation network from ports to power plants. Our calculation indicates that even if we assume no structural bottlenecks such as demand, logistics and coal availability, it still makes sense for power developers to bid for coal blocks.

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Equity Research l India coal

Power project developers will have significant operational benefits from coal blocks Coal Indias supply under FSAs has not been very regular. While Coal India has met the FSA obligations, timely supply has remained a key question. Power developers face challenges even in importing coal. Power production costs using imported coal are at least 1.5x that of the coal supplied by Coal India. Hence in merit order dispatches, there is hardly any buyer for such costly power. Transporting imported coal to the power plant site itself is difficult due to logistics challenges. Rail networks are not sufficient at many places and track congestion is becoming an issue as well. Please refer to out SCout, India coal: facing a supply crisis, dated 4 March 2012. The RoE of the power plant can reach 23% using auctioned coal Our calculation indicates that at the base price of the coal block, the RoE of the plant can easily exceed 20%. Our base price for the 150mn tonne coal block is INR 81bn: Our base case calculations use the following assumptions: Gross coal value (GCV) of the coal block of c.4,000 Kcal/Kg. Coal prices of c.USD 60/tonne and an exchange rate of USD-INR 60. As given in the methodology published on the Press Information bureau website, we have used a 15% discount to the Free on Board (FoB) prices to arrive at the mine-mouth price. Production from the coal block of 5mn tonne p.a. A discount rate of c.11% used by the government, in line with that used in the UMPP (ultra mega power projects) levelised tariff calculation. Royalty will be calculated on comparable Coal India prices for the same grade. Captive coal blocks will have to pay excise duty, but since they do not export, they will not have to pay CST (central sales tax) or VAT (value added tax).

Assuming an equipment cost of 55mn/MW, the RoE at the average selling price of NTPC will be c.23% The government has stipulated that power developers who will win the coal blocks in the auction will have to bid for the power supply agreements. In this scenario, the average cost for NTPC (NTPC IN, OP, PT 200) would be a good estimate for revenue/unit. We have assumed that the winning bid is twice the base price and the land cost has been assumed at INR 45bn for the mines. To reach the stipulated winning bid, revenue sharing from the mine will be at 15%. 5mn tonnes of coal can run a 1000MW power plant. The upfront payment for the power companies will be 10% of the winning bid prices.

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Equity Research l India coal

Figure 2: The down payment for power utilities will be a paltry c.INR 1.8bn for coal blocks with 150 mn tonnes of reserves
CY18 Production (mtpa) Prices (INR/tonne) Value of coal (INR mn) Intrinsic value Intrinsic value as on CY18 Intrinsic value as on CY13 Winning bid for power Down payment for steel/cement( INR mn) Down payment for power utilities
Source: Standard Chartered Research estimates

CY19 5 3,060 15,300 13,784

CY20 5 3,060 15,300 12,418

CY21 5 3,060 15,300 11,187

CY22 5 3,060 15,300 10,079

CY45 5 3,060 15,300 914

CY46 5 3,060 15,300 823

CY47 5 3,060 15,300 742

CY48 5 3,060 15,300 668

5 3,060 15,300 15,300 148,315 88,018 176,035 17,604 1,760

Figure 3: Even if the power developer bids at twice the base price and sells at INR 2.7/unit, the RoE will be c.23%
Cost of producing power in INR/KwHr PLF Auxiliary consumption Effective PLF Unit sales Debt/equity Debt Equity Interest rate Interest cost Per unit cost Plant life Depreciation per unit Total cost Realisation PBT Tax Pat PAT RoE
Source: Standard Chartered Research estimates

90% 8% 82% 7.1 mn units 3.0 41.3 INR mn 13.8 INR mn 10% 4.1 INR mn 0.58 INR/unit 30.0 Years 0.3 INR/unit 2.2 INR/unit 2.7 INR/unit 0.5 INR/unit 0.1 INR/unit 0.4 INR/unit 3.1 INR mn 23%

Revenue sharing Production cost Revenue given to govt Royalty Total coal cost Freight Coal cost at plant Calorific value Heat rate Coal required Coal cost Power cost Power plant cost

15% 700.0 459.0 171.0 1,330.0 200.0 1,530.0 4,000.0 2,300.0 0.6 0.9 1.3 55.0 INR/tonne INR/tonne INR/tonne INR/tonne INR/tonne INR/tonne kcal/kg kcal/kwh kg/kwh INR/kwh INR/kwh INR mn

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Equity Research l India coal

Disclosures appendix
The information and opinions in this report were prepared by Standard Chartered Bank (Hong Kong) Limited, Standard Chartered Bank Singapore Branch, Standard Chartered Securities (India) Limited, Standard Chartered Securities Korea Limited and/or one or more of its affiliates (together with its group of companies, SCB) and the research analyst(s) named in this report. THIS RESEARCH HAS NOT BEEN PRODUCED IN THE UNITED STATES. Analyst Certification Disclosure: The research analyst or analysts responsible for the content of this research report certify that: (1) the views expressed and attributed to the research analyst or analysts in the research report accurately reflect their personal opinion(s) about the subject securities and issuers and/or other subject matter as appropriate; and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views contained in this research report. On a general basis, the efficacy of recommendations is a factor in the performance appraisals of analysts. Where disclosure date appears below, this means the day prior to the report date. All share prices quoted are the closing p rice for the business day prior to the date of the report, unless otherwise stated.

INR
414.45 381.62
2

Recommendation and price target history for Coal India

348.79 315.96 283.13

250.30 Dec-10
Date 1 8 Dec 10

Mar-11

Jun-11

Sep-11
Price target 338.00

Dec-11
Date

Mar-12

Jun-12

Sep-12
Price target 334.00 395.00

Dec-12
Date

Mar-13

Jun-13

Sep-13
Price target 341.00

Recommendation IN-LINE

Recommendation OUTPERFORM

Recommendation

3 24 Nov 11 IN-LINE

5 28 Aug 13 OUTPERFORM

2 29 Apr 11 IN-LINE 370.00 4 19 Jul 12 Source: FactSet prices, SCB recommendations and price targets

INR
219.50

Recommendation and price target history for NTPC

1
2

200.49

181.48 162.47 143.46 124.45 Oct-10

Date

Jan-11

Apr-11

Jul-11
Price target

Oct-11
Date

Jan-12

Apr-12

Jul-12

Oct-12
200.00

Jan-13
Date

Apr-13

Jul-13

Oct-13
Price target

Recommendation

Recommendation

Price target

Recommendation

1 18 Sep 12 OUTPERFORM 200.40 2 21 Feb 13 OUTPERFORM Source: FactSet prices, SCB recommendations and price targets

INR
533.53 447.09

Recommendation and price target history for Bharat Heavy Electricals

360.66
1

274.22 187.79 101.35 Oct-10

Date 2 28 Jan 12

2 3

6 4
5 7

Jan-11

Apr-11

Jul-11
Price target 280.00 253.20

Oct-11
Date 4 27 Jul 12 5 4 Feb 13

Jan-12

Apr-12

Jul-12

Oct-12
186.00 188.00

Jan-13
Date

Apr-13

Jul-13

Oct-13
Price target 230.00 182.00

Recommendation UNDERPERFORM

Recommendation UNDERPERFORM UNDERPERFORM

Price target

Recommendation OUTPERFORM OUTPERFORM

1 18 Nov 11 UNDERPERFORM

6 1 Jul 13 7 6 Aug 13

3 24 May 12 UNDERPERFORM 179.00 Source: FactSet prices, SCB recommendations and price targets

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Equity Research l India coal

Recommendation Distribution and Investment Banking Relationships % of covered companies currently assigned this rating OUTPERFORM IN-LINE UNDERPERFORM As of 30 June 2013 Research Recommendation Terminology OUTPERFORM (OP) IN-LINE (IL) UNDERPERFORM (UP) Definitions The total return on the security is expected to outperform the relevant market index by 5% or more over the next 12 months The total return on the security is not expected to outperform or underperform the relevant market index by 5% or more over the next 12 months The total return on the security is expected to underperform the relevant market index by 5% or more over the next 12 months 52.6% 34.3% 13.1% % of companies assigned this rating with which SCB has provided investment banking services over the past 12 months 14.3% 16.1% 9.0%

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27 September 2013