Elixir Securities Limited – Elixir Insight

Karachi, July 12, 2018 (PPI-OT): K-Electric Limited – Reconsidered MYT Largely Unchanged; Uncertainty Still Persists

The government’s reconsideration request for KEL’s MYT was snubbed by NEPRA as the latter tackled contentions on case by case basis making no material changes. NEPRA contended that the claim of KEL running into losses was false owing to wrong set of assumptions used by the latter. As such, the regulator projected KEL’s earnings under this MYT to stand at PKR0.71/PKR0.75 in FY17/FY18 and gradually recede to PKR0.34 by FY23.

Among the notable changes, 1) base tariff was marginally raised to PKR12.82/KWH from PKR12.77/KWH, and 2) claw back limits were pushed up slightly by average of 0.27ppt across the control period. We expect them to result in no significant change in earnings profile compared with that under previous drafts.

We continue to keep KEL under review due to uncertainty regarding the implementation of this MYT. KEL has the option to legally challenge this tariff within 15 days before its notification by the government or conclude stake sale to Shanghai Electric at lower price.

NEPRA Remains Unbent; Minor Changes Allowed: After K-Electric’s (KEL) petition and request for review of favourable Multi-Year Tariff (MYT) were disregarded by National Electric Power Regulatory Authority (NEPRA), the company approached the Ministry of Energy (MOE) to file reconsideration request for a new determined MYT. The government endorsed KEL’s stance on the grounds of 1) ensuring adequate service delivery to consumers and 2) sustainability of KEL as a going concern and provide conducive investment environment for encouraging future privatization besides increasing private sector investment in power sector. NEPRA reconsidered its earlier decision and re-heard and analyzed the issues presented by KEL. Following was the list of issues addressed by NEPRA:

1. Can MYT Turn KEL into Losses: KEL projected declining profitability to result in cumulative losses of PKR144bn (PKR5.20/share) during the tariff control period. Thus, NEPRA reviewed the assumptions used by KEL in its financial projections and found following assumptions given below to be contrary to the approved MYT resulting in distorted picture. NEPRA also provided KEL’s earnings projections based on relevant set of assumptions.

I. Heat Rate and Auxiliary Consumption: KEL took heat rate and auxiliary consumption higher than those allowed in MYT thus resulting in negative impact on earnings in spite of being a pass-on component. This resulted in reducing cumulative losses by PKR21.2bn (PKR0.77/share).

II. T and D Losses: Transmission and Distribution (T and D) loss figure for FY17 was taken at 21.7% as opposed to 20.9% claimed by KEL. This resulted in reducing cumulative losses by PKR2.3bn (PKR0.08/share).

III. O and M Expense: Operations and Maintenance (O and M) expense was taken PKR37.2bn (PKR1.35/share) higher than allowed amount of PKR224bn. KEL did not provide any rational for this assumption nor did it contest it.

IV. Capital Cost in BQPS-4: KEL assumed higher capital cost of USD0.98mn/MW for its new plant Bin Qasim Power Station-4 (BQPS-4) against USD0.694mn/MW allowed. This resulted in reducing cumulative losses by PKR14.8bn (PKR0.54/share).

V. Provision for Doubtful – Recovery Losses: KEL used lower recovery ratios in assumptions than recovery ratios with progressive improvement. This resulted in reducing cumulative losses by PKR60.8bn (PKR2.20/share).

VI. Depreciation on Revalued Assets: Depreciation expense was assumed to be PKR45.1bn (PKR1.63/share) higher than allowed depreciation as the company booked the cost on revalued assets rather than on historical cost of assets.

VII. Short Term Borrowing: KEL’s assumptions led to forecasted short term borrowing of PKR421bn which was drastically reduced based on rectified assumptions. This resulted in reducing cumulative losses by PKR45.4bn (PKR1.64/share).

VIII. Spread on Short Term Loans: KEL assumed spread of KIBOR + 4% on short term loans which was significantly higher than reasonable assumption of KIBOR + 2.5%, which reduced its cumulative losses by PKR11.8bn (PKR0.43/share).

2. Can MYT Have Adverse Implications on Consumers: KEL expressed that it will not be able to 1) undertake investment which could reduce growing demand-supply gap, 2) provide new connections, and 3) reduce reliability on other sources (i.e. NTDC). NEPRA criticized KEL for mainly focusing on improving profitability through retention of efficiency gains in Generation segment despite slack in quality of service to consumers, stagnant recoveries ratio, and T and D losses target lagging behind benchmarks in preceding control period. Thus, current MYT was specifically structured to ensure investment made in each segment to achieve better service delivery. KEL is offered pre-determined rate of return on fixed assets, thus, incentivizing it to reap benefits through sales growth and efficiency gains in Transmission and Distribution segments. Besides, KEL is offered adequate revenue stream to ensure its sustainability and viability.

3. Whether Consideration of Recovery Losses Based on Lower Recoveries Justified: KEL expressed that bad debt allowance of 1.69% (as a percentage of net revenue) was too low compared to actual recovery of 87.6%. It will create severe liquidity issues and negatively impact planned investments. KEL resented that lower recoveries were plagued by governance issues, weaker rule of law, violence and crime etc. It also complained that pursuing legal forums for such volume of default cases (approximately 550,000) is not practical and the recoveries may not be more than the legal costs. Thus, it requested year wise recovery target benchmarks.

However, NEPRA contended that besides allowing 1.69% recovery loss KEL can also claim additional write-off on actual basis after fulfilling the prescribed process. This decision was in line with international best practices wherein a reasonable recovery loss (generally a small percentage) is allowed to be recovered. Moreover, considering law and order challenges, additional margin of 5.2ppt in T and D losses has been allowed to KEL. NEPRA criticized KEL for declining in recoveries from 88.6% in FY09 to 87.6% in FY16. The decision to not pass through complete recovery losses was consistent with the treatment of other Distribution Companies (DISCOs).

NEPRA advised the federal government that rather than requesting to pass on the burden of lower recoveries to consumers, it should ensure timely payments by all Public Sector Entities (PSEs). Along the same line, NEPRA recommended provincial government to provide effective law enforcement to ensure full recovery by KEL. With regards to KEL’s assertion that the city dynamics are different from other DISCOs and its comparison being unjustified, NEPRA noted that it included all good and bad territories and with their combined performance faring better than that of KEL in respect of T and D losses and recoveries.

Addressing concerns of financial institutions, NEPRA stated that it was mindful of late/non-payment of bills which may lead to cash flow issues for which KEL is already being compensated through Late Payment Surcharge (LPS) that is sufficient to cover both recovery losses and other working capital requirement. Additionally, NEPRA may review working capital needs of KEL if there is material change that could impair its ability as a going concern entity. Parsing through recoveries by Integrated Business Centers (IBCs), 64% of revenue contribution is attributable to IBCs with recoveries above 93% whereas KEL needs to make improvement in IBCs contributing 34% of revenues which have recoveries of 76%. This led NEPRA to conclude that current recovery target is realistic and achievable and does not merit revision.

4. Whether Performance Based Tariff be Retained: KEL requested performance based tariff similar to previous MYT be allowed. The company lamented that the fixed-rate structure with locked investment plan of PKR299bn (Generation/Transmission/Distribution: PKR97bn/PKR128bn/PKR74bn) provides no incentive to improve generation efficiency through induction of new plants. KEL touted the success of this tariff regime which resulted in PKR130bn investment, improvement in fleet efficiency from 30% to 37.4% and decline in T and D losses from 36% to 22.2%.

NEPRA argued that this tariff structure has been developed to ensure KEL optimize returns through increase in sales, lower T and D losses and reduction on O and M expense rather than reap gains through generation efficiencies as in performance based tariff. With regards to issue of inflexibility in investment plan raised by KEL, NEPRA countered that it has set a mid-term review to be carried out after 3.5 years to make changes for base rate adjustments, besides the company can churn gains through excess investment in Transmission and Distribution above target than the company can retain efficiency gains, however, no changes would be made to base rate. Investment in Generation business would be subjected to NEPRA’s approval, which would determine the base rate adjustments accordingly.

5. Whether RAB Based on Capital Employed Justified: KEL communicated that its Regulatory Asset Base (RAB) calculated through written down value/cost basis is significantly lower compared with RAB based on capital employed (equity + debt), thus, it would result in lower returns. NEPRA contended that new RAB approach has to be adopted to encourage more investments for asset creation for system expansion and rehabilitation, and to ensure reliable supply of electricity. Following aspects were considered for RAB: 1) exclusion of deferred tax assets from equity which does not reflect actual equity employed, and 2) usefulness of asset rather sources of funds.

NEPRA also reasoned that KEL intended to invest in IPPs which would create double burden on consumers as it would be earning return on the same investment through both MYT and IPP mode. While there is no standard definition of RAB, asset based RAB is in line with global standards. KEL requested return on invested equity be allowed which will ensure reinvestment of profits, similar to Generation Companies (GENCOs). NEPRA rejected this request as it said KEL was offered similar tariff in previous MYT to ensure improvement in efficiency which is now not required. Besides, KEL is offered higher ROE of 16.9% compared with GENCOs ROE of 11.2-13.9%.

6. Whether Tariff Based on Actual Debt/Equity Justified: KEL aggrieved that debt/equity of 70/30 was determined on notional basis compared with no condition on capital structure in previous MYT and requested that actual debt/equity be allowed. NEPRA rejected the request saying that notional amount is widely used and KEL is offered the maximum equity participation out of 70/30 – 80/20 range and no preferential treatment can be given. With regards to comparison to previous MYT, NEPRA stated that no limit was defined on debt/equity as KEL was allowed to invest regardless of capital structure. Since cost of debt has been added, there is no justification for change in capital structure.

7. Whether USD Indexed Returns for Transmission and Distribution Justified: KEL requested that owing to higher operational risks it should be allowed higher USD based ROE on Generation/Transmission/Distribution of 17%/17%/18.67% (2ppt higher on account of risk premium) besides quarterly USD indexation instead of current notional indexation factor of 2.56%. KEL also requested 17% ROE on Transmission as offered to Lahore-Matiari transmission line. NEPRA rejected this request as it argued that 15% ROE was also offered to Sindh Transmission and Dispatch Company (STDCL) whereas Lahore-Matiari Transmission is offered 17% ROE as it is the first High Voltage DC transmission line venture in the country. However, NEPRA was cognizant of exchange rate risk and allowed USD indexation of ROEs of Transmission and Distribution segments.

Base Tariff Increased by PKR0.05/KWH: Though NEPRA rejected major requests for review and reconsideration, it gave approval to KEL’s demand of O and M component’s indexation based on X-factor in CPI-X% to be lower of 30% of CPI inflation or 2%/2%/3% for Generation/Transmission/Distribution) as it acknowledged recent inflationary trends. Besides, base rate adjustment was increased to PKR1.059/KWH from PKR1.074/KWH to ensure 14.10% WACC offered to KEL. As such, KEL’s base tariff increased marginally though to PKR12.82/KWH from PKR12.77/KWH. KEL’s claw back limits were revised up slightly by average of 0.27ppt across the control period. Whereas, T and D benchmarks were kept at previous levels. These developments are not expected to result in material changes in earnings forecast.

KEL Under Review Due to Uncertainty of This MYT’s Implementation: We continue to keep KEL under review due to uncertainty regarding the implementation of this MYT. It will be notified by the government within 15 days unless legally challenged. Although KEL can conclude its stake sale to Shanghai Electric at lower price, we do not expect the embattled sponsor Abraaj to opt this route. To put things in perspective, we have provided our EPS projection based on this MYT where valuations indicate Price Target of PKR6.2/share.