Any Bombay Club industrialist would have told you (if you had bothered to ask). A good business model is one where the cost of capital is already subsidized by someone else. Dhirubhai set up his great empire by effectively reducing the Cost of Capital of his projects to near zero. The Birlas will tell you that good Project Management is the critical differentiator in all commodity businesses.
Declaimer: This article written was originally in March 2010 and some of the data points may be outdated.
Our Govt needs to understand this. An economy is nothing but a collection of economic activity, most of which is business, especially big business. Some companies/ individuals save, and some borrow; if the actual cost of debt is above inflation, value is transferred from the borrowers to the savers. This is traditional economic theory; you don’t need me to tell you this.
The critical thing about Clean Energy is not that the capital cost (of solar, etc) is high, but that its Variable Cost is NIL. If the Capital Cost is charged to someone else’s revenue, then it is a ‘frictionless’ business, i.e. a business with only profits, no costs.
Read that again. Right now, Solar energy is viable, even at Rs.12-13 cr per MW vs. coal at Rs. 5 cr per MW. Against coal’s Variable Cost of Rs. 1.2 per unit, Solar would be near zero, say, Rs.0.05 per unit. The only real cost in the DCF is the Interest Cost on the Capital Cost differential, and the Cost of Equity (a.k.a. payback period), which is typically 5 years in India. I have ignored depreciation because a thermal plant will also depreciate at the same rate.
If you have $ 8 trn to invest into an (American) black hole, wouldn’t you be relieved that some of it is going into a capital asset with an assured return of both Interest and Dividend, over whatever period? So I can understand that the OECD countries are secretly happy at this new opportunity. It is like how an earthquake in a mature economy like Japan is good (economic) news because the reconstruction will generate jobs and economic activity; savings was anyway never a problem in Japan.
Savings is not a problem in another place, called India. Channelizing it into productive resources, especially those routed through Govt initiatives, takes some thinking. At about 37% savings: GDP ratio, we were headed into another Japan-like situation, as we mature into a slow-growing economy. Yes, I know, that is very far away, but it would have happened someday, wouldn’t it?
So is that what we are crying about, that we are a capital-short economy, despite a whopping Savings rate; and the Govt, especially, is always short of funds, because of an abysmal tax: GDP ratio? Isn’t there a way around it, just that nobody wants to look at such dramatic solutions?
What we are really looking at, is just a way to fund the Capital Subsidy needed to bring Solar on par with Thermal. This cannot come from a bankrupt Govt, which anyway has to turn to deficit financing, every time it suffers some small shock. That is because we have over-stretched finances, coming from all those distortions in energy and food subsidies. We actually pay our people to misuse energy, while the world is learning to use energy efficiently. We can simultaneously talk about reducing the carbon intensity of GDP while refusing to free energy prices. As if this were not enough, we can actually talk about water conservation, even as we fight to keep water free and subsidized. How can something be precious and free at the same time? Ask the Govt…..or the Opposition Left/ BJP!!! As the song says, it happens only in India!!!
So cut to the mechanism to fund Capital Subsidies for Solar. If we are all agreed that an appropriate tax: GDP ratio is closer to 25%, then there is some $100-120 bn (10-12% of GDP) lying outside the system. Of this, 3% of GDP, say $ 30 bn of taxes, is lost from agriculture, which is a holy cow. Which politician is willing to tax himself? So that leaves 7-10% of GDP, waiting to be harnessed through a market mechanism, that funds such a (Solar) Capital Subsidy outside the Govt ambit.
Set up an apex body like IDFC, exclusively for Clean Energy initiatives. This will be a holding co, that funds debt and capital needs of various Solar generating cos. A set of rules is designed, and a model is worked out, a hybrid of debt, mezzanine funding, and pure Equity in a ratio that keeps the cost of capital (and the average tenure of maturity) within a reasonable norm. The difference (in cost and tenure) between this Liability Profile and that of the markets, will be borne by the IDFC-like body.
So draw up 2 DCF statements: one, for a normal Thermal Power plant. Put in the 3:1 debt: equity norm, price the debt at, say, 10%, and work out the tariffs at Rs. 2.2 per unit, and a Variable Cost of Rs. 1.2 per unit. You will get a certain IRR, say, 15%.
Now make another DCF. The cost of debt is 8%, but there is a Pref Cap/ Subordinated debt at, say, 12%, giving you a blended cost of the same 10% (assuming a 1:1 mix). Take equity as the balancing figure, but come to a blended cost of capital that is the same 11% WACC that is used by the wider market. The important thing is that if the Payback of the Solar project takes longer, the ‘rollover risk’ is guaranteed by the Clean Energy corporation, which, being a Govt body, passes through a Govt guarantee to the investors.
Now here is the catch. The Govt only contributes a notional amount to the Equity of this Corpn, which is a Class A share, 100% held with the Govt. The entire Operating Corpus of the Corpn is raised from the public, in the form of bonds, and the subscription to the bond attracts a tax break from current income to the extent of 100% of the amount invested. That is like giving a 35% subsidy to the investor; although since mostly black money will flow into this, the imputed credit that the investor will give (in his mind) will be closer to 15%. So that is like pricing the bond at Rs.85, not Rs.100 per bond, even as the coupon rates and market prices are determined by market forces. Needless to say, it will be a “no questions asked” scheme.
So why will all taxpayers not opt for this bond, is the $300 bn question? Because if I know human behavior, the cost of capital of black money is very low. Look at black money lending markets anywhere; in Jaipur, it is a low 2-3%, while bank deposits yield 6% for the same tenures. Honest people who pay taxes will seek higher yields; those with a mindset of evading or not paying taxes at all costs will choose the bond route. The bonds will have a steep ‘yield curve’ depressed by the sale of the bonds immediately after subscription; these sales will be pressed by those who want to strip out the tax benefit. Normal clean money will flow into the bond as it gets closer to maturity, and an arbitrage market will emerge to bridge the difference.
Remember, these are Govt bonds, so banks can start making a market in these. The spin-off benefit, your $200 bn capital subsidy needed to build 20,000 MW capacity will be funded painlessly. In fact, the momentum built by such a market can be used to finance any long – gestation project that is good for the country and otherwise needs public money to be funded. The River Linking Project, Water Desalination Projects, and various water recycling/ micro irrigation projects come to mind…
I know all this is a little complicated, but if it catches someone’s eye in Govt, I would love to flesh it out for them. I think Clean Energy (and Water Recycling) are the only way forward for a country that is otherwise facing sure calamity because of Global Warming effects.
