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Expect bruises, not bubbles in India’s solar market

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The Indian solar market is growing at a breathtaking speed: This year alone, by more than 300%, next year perhaps by 150%. Competition is as intense as the market is enthusiastic. Projects are being won at record low tariffs – tariffs that many observers doubt will leave investors with acceptable returns. Will these projects be “stranded solar assets”? Is there a bubble in the making? Richard Martin has recently asked this question in the MIT Technology Review (refer). My answer is a clear “no”. Here is why.

Some investors will be disappointed with returns as competition remains stiff

Power demand in India is high and growing – it is a solid business opportunity

In future, as financial engineering becomes more complex, there might be more room for speculation

Bubbles are typically seen in the stock, commodity and real estate markets, which have a tendency to detach themselves from economic fundamentals and propel valuations to excessive heights, driven by a mix of unreasonable expectations and speculation. We are currently watching in awe, if the Chinese stock market is a bubble about to burst. Is solar in India comparable?

There is some degree of unreasonable expectations and speculations in solar in India. Not all investors will be happy, not all developer strategies will work out. Overly aggressive bids might lead to projects that don’t make sufficient returns to warrant the risks, or even be loss making. However, we are talking about a bandwidth of 5-8% in the equity returns – a bruise, not a total write-off.

Moreover, there is no reason why individual projects that fail should have a negative impact on the market as a whole. The worst that can happen is: some projects will not get built and some other projects get built but underperform (e.g. because quality and technology corners have been cut), and some investors and banks will lose money. Also, some investors with high hopes but without a unique selling proposition or a pliable strategy will be disappointed. It’s normal business risk.

There is even a good chance that low-margin projects might get refinanced in the future, probably while being bundled into larger portfolios. This option partially depends on the continued availability of low cost equity and debt in the US, in Europe and in Japan. In some parts of the world, this cheap money might build infrastructure that is not required (a bubble).

Generating power in India, however, is actually a fairly safe bet in terms of providing something that is fundamentally needed. The country has a power deficit and demand will likely grow. Indians, on average consume only around 1,000 kWh a year – less then 10% of the consumption of an average American. As opposed to earlier “green” (read: artificial), incentive-driven solar markets that came to an abrupt halt after 2008 (Italy, Spain), the Indian solar market is driven by the country’s vast thirst for energy and solar is rapidly becoming a competitive choice even without government support (refer). Let’s put this market into perspective, too: Solar currently makes up only 1% of India’s energy supply. If the government’s ambitious target is realized it will be just over 10%.

Even, if you take a pessimistic view and believe that India’s economy and energy demand will not grow so fast and that, with current investments in the power market, there might be overcapacity, it is unlikely that solar assets will be hit. Since the marginal cost of generating a unit of solar power is zero, it would make little sense to throttle solar power plants and much more sense to reduce generation from fossil fuels. Thus, if anything, there is a risk of stranded fossil fuel assets in India (refer).

Could a bubble emerge in the future? The solar projects we currently see in India can generate stable returns through PPAs fixed over a long period of time. In the future, investors might take more risks, by, for example, selling power through speculative shorter-term deals (for instance at the power exchange). In addition, there might be market aggregators trying to sell such portfolios at unreasonable valuations and assumptions about future revenues to insufficiently informed and/or highly speculative investors (currently, there are very few aggregators). At some point, these portfolios might even be repackaged and resold in a way that obscures risks (as sub-prime mortgages were sold through credit default swaps before 2008). Then, we might see a bubble emerging. We have to observe closely, for example, how “Yieldcos” are developing, that sell Indian asset owning companies to investors in the e.g. the US (as SunEdison is doing).

Currently, however, the market is far away from generating a bubble.

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Renewables in India: Bringing it All Together

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Recently, the Ministry of New and Renewable Energy (MNRE) released a draft of the “National Renewable Energy Act” (refer). Along with the proposed amendments to the Electricity Act 2003 and the National Tariff Policy 2005 (refer), this act will create structural policy changes to help increase the share of renewables in India’s energy mix. In the first section, the document describes in detail how institutional structures would be created. However, it is the subsequent sections that have caught our attention. This is our take:

National, uniform and mandatory regulations will govern renewable purchase obligations

A “National Renewable Energy Fund” will be created and a fixed portion of the National Clean Energy Fund will be directly channeled into it

There will be guidelines for renewable energy procurement, including but not limited to competitive bidding processes

The first interesting point relates to getting India’s states on board. The Renewable Energy Act envisages that the central government and each state government will formulate a renewable energy policy and a renewable energy plan. As a part of a “National Renewable Energy Plan” a framework would be created for a national, uniform and mandatory renewable purchase obligation (RPO) trajectory for all obligated entities. Currently, each state fixes its own trajectory for RPOs and solar RPOs that have been set still relate to the earlier, lower national target of 3% (it is now 10.25%). This is in addition to earlier changes of the the Electricity Act and Tariff Policy amendments, where provisions have been made for imposing fines for non-compliance and easy pass through of costs through tariffs for effective compliance.

We understand that the fundamental problem that power is a concurrent subject still remains. However, the central government has several levers that it can use to get states to toe its line. Availability of funds and a clout in fuel supply, power generation and power transmission through central government owned companies are examples of such levers. In the past, the push for renewables from the central government has not been as strong as it seems now. Usually, state governments do not have a lot of incentive in deviating too far from the central government policies. We are hopeful that this on-going effort will yield results on setting up and implementation of obligations.

A second interesting point relates to India’s National Clean Energy Fund (NCEF). This fund is provisioned by an INR 200 cess on every ton of coal used in the country (the cess was just doubled in the last budget in February this year). The fund has a current corpus of INR 170 billion (USD 2.6 billion) (refer). However, only a small portion of this fund has been made available for renewables. In the past, it was used mostly for fiscal troubleshooting with very little transparency. The new Renewable Energy Act now proposes to set aside a fixed portion, yet to be determined, of the funds for a separate National Renewable Energy Fund. This fund will be under the control of the relevant implementing authorities, primarily MNRE. With more clarity on availability of funds, MNRE can set up more predictable support and policy schemes.

A third noteworthy suggestion relates to creating a more uniform project allocation process. Currently, most allocations in the country are based on tariff bidding against benchmarks set by various regulatory commissions. The proposed amendments to the National Tariff Policy 2005 provides for a provision for obligated entities procuring solar power on a cost plus basis from conventional power generators who need to meet their Renewable Generation Obligation (RGO). This can have huge implications on the solar market in India. It is essential that the process for such allocations is completely transparent and provides a level-playing field. In light of this, the draft Renewable Energy Act states that the ministry would publish guidelines for procurement mechanisms, including but not limited to competitive bidding processes.

With the proposed amendments to the Electricity Act 2003, the National Tariff policy 2005, the announcement of National Renewable Energy Act 2015, the expected announcements on the national and state Renewable Energy Policies and Renewable Energy Plans, a near complete demand creation framework for renewables is being formulated at the central government level.

All these bills need to first pass the hurdle of the legislative process in the Parliament. While the Electricity Act amendments have already been tabled, the Tariff Policy amendments and Renewable Energy Act should be ready by the winter or latest by budget session (later part of the financial year 2015-16). Following this Act, the central government would introduce a renewable energy policy and a renewable energy plan and also facilitate state level renewable energy policies and state level renewable energy plans.

It seems that this entire framework will require at least until the middle of 2017 to become operational. Until then, the government wants to provide an early push and allocate up to 15,000 MW of solar projects under the current framework.

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Evolution or Revolution? How renewables will shape our future

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In the early 20th century, when cars started to compete with horse-drawn carriages in Europe, they still had innumerable technical teething issues and no distribution channels. Germany’s last emperor William II famously said (possibly while sitting on a horse): “I believe in horses, automobiles are a passing phenomenon.” Well, you know which side of history he was on. Cars, of course, did not only complement horse-drawn carriages, they replaced them. I would argue that we will see something similar in our energy future, where renewables will not only complement, but replace fossil fuels.

Most energy projections see a gradual shift in the energy mix

However, as the cost of renewables continues to fall quickly, the shift may be much more radical and abrupt

Investors may preempt this development and pull the shift forward even more

I was just reading two excellent macro-level takes on the global energy future and the economics of renewables. One was Scott Nyquist’s very interesting discussion in McKinsey Quarterly of why renewables have been so resilient in the face of low oil prices (which was supposed to be “like Kryptonite to Superman”, see here). The second was the new Energy Outlook by BNEF (including a fantastic new data visualisation, see here). The BNEF outlook predicts very strong growth for renewables until 2040. They will make up 2/3rd of the $12 trillion investment into new power plants until then.

They argue, however, that despite this growth, fossil fuels will maintain a 44% share of the market in 2040. Our energy mix will evolve over time in a gradual manner. If you look at the predictions of e.g. the IEA or BP, the picture is the same. Aside from the fact that this gradual shift – even, if accompanied by rapid growth in renewable energy investment – will not get us to where we need to be from a climate perspective, I wonder, if this is the right way of projecting our future energy mix.

When comparing fossil fuels with renewables, we are comparing two very different things. Fossil fuels are (as the name says) a fuel. They are dug up and converted into electricity in power plants whose technology is very mature. The fuel cost makes up around 4/5th of the cost of power.

Renewables (I here refer mainly to wind and solar), on the other hand, are a technology. The energy source is free. We invest into the conversion technology which makes up almost all the power cost.

Over time, as the BNEF report shows very well, renewables will become cheaper and cheaper (the more you deploy a technology, the cheaper/better it gets), becoming the cheapest power generation source in most places. In addition, as the article by Scott Nyquist shows, the cost of storage is coming down very quickly. This will create a world, where renewables can supply reliable power at the most competitive rates. What does that mean?

It will, of course, affect new investment choices. More money will go into renewables and less into fossil fuel power plants (as BNEF writes). This will change our energy mix – slowly. But will that be all?

I would argue: no. In addition to this evolutionary change, there will be a revolutionary change. I.e. At some point, we will see a sudden drop in the use of fossil fuels and a sudden uptake in the use of renewables. By 2040, I can imagine renewables are simply replacing existing fossil fuel plants, as it will be cheaper to build a new renewable power plant (technology) than to operate an existing fossil fuel plant (fuel).

In fact, this condition will likely be anticipated by investors, who will stop investing into fossil fuel plants even before the actual tipping is reached. Why would they invest into a new coal fired plant and why would governments/distribution companies sign long term PPAs, if the power it produces will be competed out of the market a few years later?

The basic economics of energy will ensure a rapid energy transition. This will be disruptive and there are big questions about how it will happen. Will gas consumption spike? Will distributed generation take over? Etc. However, it will not be the smooth, evolutionary path outlined in most future energy mix predictions. It will be much messier (and, of course, much harder to predict in detail)

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Madhya Pradesh bid results: record low tariffs, tight margins

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Last week, 300 MW of solar capacity was auctioned in the Indian state of Madhya Pradesh (MP). The record low tariffs surprised most observers. Canadian developer Sky Power offered to sell solar power at INR 5.05/kWh (50 MW capacity). The bids closed at INR 5.64/kWh with the median tariff at INR 5.34/kWh. The auction received a lot of interest and over 2,200 MW of projects were offered at tariffs below INR 6/kWh.

Solar tariffs in India are falling dramatically

At these tariffs, effectively, there should be no need for incentives anymore

Are return expectations sufficient for scaling up?

At these tariffs, our estimate of equity IRRs is between 11-15% assuming market standard technical and financial parameters. These returns are too low in the Indian context but before we get into the implication of these bids on the project development landscape, let us first look at the bigger picture and the results for the solar and power sector in India.

Recently concluded bids for new coal-fired power capacity in Andhra Pradesh saw winning tariffs of INR 4.27-4.98/kWh. In 2013, in Rajasthan and Tamil Nadu, coal power was bid at INR 5.41-5.66/kWh (refer). With the new MP tariffs, solar power seems to have graduated to become a mainstream option for power generation in the country. Effectively, there should be no need for incentives anymore – at least up until the point when grid limits are reached and balancing becomes necessary.

This begs the question about the future of the upcoming viability gap funding (VGF) scheme to be implemented by SECI where the proposed levelized tariff is at INR 5.79/kWh (set at INR 5.43/kWh for first year with an escalation of INR 0.05/kWh for next 20 years). This, along with the results from the upcoming NTPC tender will require recalibration of benchmarks for these bids. In another proposed project of 750 MW in Madhya Pradesh with 50% funding from World Bank, the proposed tariffs should be reconsidered. All this suggests that solar is moving faster than expected.

Though the availability (supply) of projects is set to grow by a factor of 10 this year (from 1 to 10 GW), margin pressure does not seem to ease off. Existing and new players are aggressively building ever larger portfolios. This Madhya Pradesh allocation of 300 MW was oversubscribed by over 1,200%. The ongoing allocation for India’s largest tender till date for 2,000 MW in Telangana was also oversubscribed by 250%.

If these indications are anything to go by, India has already come to a stage where the country can shift focus from direct fiscal support to solar power to strengthening the transmission infrastructure, building balancing capacity for the grid and normalizing power prices. Even the implementation of Renewable Purchase Obligations (RPOs) looks within reach.

However, many industry stakeholders argue that return on their investment is not sustainable for scaling up. There is obviously merit in that argument but the government is not too concerned about it as it sees investments and commitments continuing to pile up.

The way things are going, it seems that competition amongst the solar developers will soon be replaced by solar competing with other sources of power in the country. In that process, margins might recover.

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Lowest Tariffs, Accelerating Growth: How India’s Solar Market is Changing

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A year ago, the Indian government announced a goal of 100 GW of solar by 2022. Large parts or the markets (including us) were skeptical. In the last couple of months, however, the mood has changed.

We revise our growth projections for 2015 up from 3 GW to 4.5 GW

Solar tariffs have dropped to as low as 5.05 per kWh

Some stumbling blocks remain

These are the reasons to be optimistic:

Real growth on the ground:In the last three years the Indian market grow by 1 GW per year. This year, India is expected to add as much as 5 GW (1.1 GW already commissioned). Until recently, our estimate was 3 GW but now revised our projections upwards (see our India Solar Handbook). In 2016, India may add 7-10 GW of solar (the government plans to auction 10 GW this year).

Radical fall in tariffs:The most competitive bid in October 2014 was INR 6.01 kWh for a 40 MW plant by US-based First Solar. In the just opened bids in Madhya Pradesh, the highest winning bid was INR 5.64/kWh for a 50 MW plant by Indian developer Hero Future Energy and the lowest bid was an incredible INR 5.05/kWh for a 50 MW plant by Canadian developer Sky Power Solar. (Globally, the lowest tariff is from developer Acwa in Dubai at $ 0.06 or INR 3.8 per kWh – earlier this year.) That brings utility scale solar to a point where it may no longer need government support. For instance, the benchmark tariff set by the government, starting from which project developers are to bid for Viability Gap Funding in the upcoming NSM auction is INR 5.45/kWh. At this rate bidders should offer the government money to sign power purchase agreements! Consider also, that the price for new thermal power from coal in India is between INR 4.5 and 5/kWh. In future, as solar project sizes will further rise and costs fall, we might see the market turn towards providing “dispatchable” power, with solar complemented by e.g. wind and gas.

New players in the market:The Indian solar market is maturing fast. A good sign of that is the rapidly rising interest of large, professional international players. A game changer in the market was the announcement by Softbank (Japan) to invest $20bn into the Indian solar market over the next 10 years together with partner Bharti (India) and Foxconn (Taiwan) (link). This was followed by announcement by Russia’s Rosneft to build up to 20 GW of solar in India (link). In addition, there is significant interest from global solar companies, from private equity investors and from international utilities. Some of this interest is linked to shifting global dynamics in the energy markets, but the larger part is due to renewed investor confidence in India.

While this is all very encouraging indeed and points towards India becoming one of the most dynamic solar (and, in fact, energy) markets in the world, there still are some stumbling blocks.

Margins: It remains difficult to earn money on solar projects in India. There is strong competitive pressure on tariffs and that percolates down through the entire value chain, leaving bare bone margins of around15% (at a debt cost of 11-13%), if at all. Why is the interest so high, then? Leaving aside a group of players who are overoptimistic, take undue risk or lack market information and a (relatively small) group of players who muscle into the market with strategic pricing, there is a widespread assumption that building a portfolio of projects generates value above the returns of individual projects and that there will be attractive ways of refinancing later.

Weak grids, weaker discoms: The Indian electricity grid suffers fromhigh losses (20%+), frequent technical failures and a lack of monitiring and maintenance. It is the opposite of a “smart grid”. In order to absorb much more volatile renewable power (and in order to deal with India’s future growth in energy demand) it would need to be bolstered significantly. The trouble is, the utilities are in very bad financial shape. Their cumulative losses are around US$ 50bn, with annual losses of around $10bn. This financial situation makes utilities reluctant grid investors and non-bankable PPA counterparts.

Power pricing:This is the biggest immediate concern. Different tariff groups in India pay different rates for power. Industrial and commercial customers cross-subsidise agricultural customers. And since the cross-subsidy is insufficient, there is a deficit – see point above. Agricultural rates range between 0 and 2 INR per kWh. Utilities often prefer to load-shed (scheduled blackouts), rather than supply power to these customers at a loss. This limits their interest in buying any new power at all – whether coal, solar or other. The rationalisation of power tariffs is therefore a key task to enable not only the Indian solar market to grow, but ensure a healthy overall electricity sector and the provision of reliable power to consumers.

If India manages to mend its overall power sector, there is little stopping solar – especially when it will, through hybridisation and storage, be able to provide competitive, reliable power in the years to come.

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Solar policy vs. DISCOMs – Round One

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One group in India that has so far not shared the enthusiasm about the country’s solar ambitions is utilities. Their immediate concerns relate to how the transmission and distribution grid is used and paid for. At a more fundamental level, they are wondering about whether the growth of solar will restrict or change their role in India’s future electricity system. While some DISCOMs have been more proactive, viewing solar as an opportunity, others have been dragging their feet. This has been a key determinant of whether or not solar has take off in different states. Andhra Pradesh is one of the most solar enthusiastic states in India – but the state’s DISCOM is now challenging that. The Eastern Power Distribution Company of AP Limited (APEPDCL), has petitioned the state electricity regulatory commission, APERC, to review exemptions from wheeling charges for renewable energy (refer).

Andhra Pradesh was a leading state in announcing a waiver of wheeling charges and has since been followed by several others

Regulatory changes after the investment has been made can be very damaging to the investment climate. The petition in Andhra Pradesh is a reminder of the uncertainties of the business.

BRIDGE TO INDIA supports fair compensation for use of infrastructure but that should not be confused with seeking to protect distribution monopolies

State DISCOMs impose wheeling charges on the use of their transmission infrastructure. A waiver from wheeling charges is an incentive for the renewables sector, essentially a subsidy. APEPDCL argues that it is currently losing revenue due to such waivers and will have to bridge the revenue gap by hiking tariffs for non-solar customers. For this reason, it has asked for the waiver to be scrapped. We expect many more such challenges to solar in India.

Andhra Pradesh was one of the first states in India to announce a waiver of wheeling and some other open access charges for captive use/private sale of power from utility scale solar projects. This decision was hailed by the solar industry and similar policies with full or partial waiver of various open access charges were announced in Karnataka, Madhya Pradesh, Tamil Nadu, Punjab, Uttarakhand and Punjab. The trend so far was towards expanding this model. The central government, for instance, has proposed changes to the National Tariff Policy 2005 to allow free interstate transmission of renewable power.

With falling solar prices and rising grid power tariffs solar power has become an attractive choice for more and more customers. This has prompted several developers to look at private solar parks and other such business models seriously. According to BRIDGE TO INDIA’s project database, over 100 MW of off-site, private sale of power sola projects have been built. Many developers are currently looking at such opportunities through the solar parks being built in Madhya Pradesh, Telangana, Rajasthan, Tamil Nadu and Andhra Pradesh.

A key concern investors and especially banks have had with such projects has been the longevity and stability of waivers from various charges announced as part of ambitious state policies. Despite grand vision statements, actual regulations can change quickly and in India, they are almost never protected by a ‘grandfathering’ clause (refer). Regulatory changes after the investment has been made can leave investors in a lurch. The petition in Andhra Pradesh is a sharp reminder of such uncertainties.

BRIDGE TO INDIA is of the opinion that DISCOMs should be fairly compensated for use of their infrastructure. However, this compensation should not be used to shut out new entrants and maintain monopolies. If states want to provide such incentives to the solar sector, then DISCOMs should either be allowed to pass these costs on to other customers or the government should compensate them for it.Otherwise, similar policies in other states, especially policies such as Karnataka’s 10 year waiver on wheeling and other charges, will not be sustainable. So the issue needs to be addressed keeping in mind the interests of all stakeholders. It is equally important, however, to build investor trust in the Indian market and from that perspective, overturning any policy for existing projects should be a strict no-no.

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Why “Swaminomics” is wrong – solar has passed the point of no return in India

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On Sunday, 5th June 2015, one of India’s leading economic journalists, Swaminathan Aiyar, in his weekly column “Swaminomics”, wrote that India should wait for five years before trying to implement big plans for solar (refer). He argues that solar is still a comparatively expensive energy generation technology and that because India is an evening peak country, increasing the share of solar would be a “double whammy”, by driving up indirect costs for thermal, peak power generating sources. As a result, he concludes, India should go all out on solar only after it is fully established that the cost breakthrough has been achieved and the technology is more mature. While there are interesting insights in the article, we disagree with his conclusions. Here is why.

Solar costs are not as high as Swami claims. In fact, upcoming NSM bids will show that it’s neck to neck with new thermal projects.

India is an evening peak country right now but as the economy develops the peak will move into the daytime (cooling).

Global investors already see the social and economic appeal of solar and are moving out from coal to the sector.

Let us look at the first part of his argument – that solar is still very expensive. Swami takes the recent signing of PPAs in Tamil Nadu to arrive at the benchmark cost of INR 7.01/kWh for solar power. However, this is not India’s benchmark solar price. Developers signing PPAs in Tamil Nadu take state-specific risks and costs, and expect higher returns. The real cost of utility scale solar can better be judged by the bidding in the upcoming central government allocations in the neighboring state of Andhra Pradesh. Here, the costs are expected to fall to about INR 5.50/kWh or even lower.

These costs should then be compared to the marginal cost of other sources of power, or simply put, the cost at which new conventional power plants are willing to sell power. Recent bids for new thermal power capacity in Andhra Pradesh saw tariffs at INR 4.27/kWh to INR 4.98/kWh (refer). In 2013, in Rajasthan and Tamil Nadu, thermal power prices where even higher at INR 5.41/kWh and INR 5.66/kWh (refer). Add to that the future price volatility of coal versus the locked-in cost of solar (for 20 years), and solar is already far more competitive than Swaminathan would have us believe. Going forward, the largely undisputed trajectory of solar costs is downwards.

The second argument put forward in Swaminomics is that India is still an evening peak country and despite a large capacity of solar, peak power generating stations will still need to be built and they might be required to run at lower utilization rates in the day time due to the availability of solar power. This, he writes, would lead to increased power costs in the country. This is a valid concern but this argument is true for almost all infrastructure sectors. Roads, airports, railways and shipyards are all to be built to handle the peak traffic and not the base (at least they should be!). In the power sector, there are two peaks to consider: The daily peak and the seasonal peak. Hydro power provides some of the lowest cost electricity, but generation peaks during and after the monsoon, while India’s demand peaks during the hot and dry summer months, when – incidentally – solar produces the most. As intermittent sources of power become cheaper and diversification for energy security becomes a necessity, like the rest of the world, India will need to leave the comfort of almost completely relying on steady power sources such as coal and nuclear and develop a “smart” (read: nimble) energy infrastructure. Moreover, India’s peak power requirement will also slowly move to the day time as we grow and develop and cooling will play an every more important role. In the meantime, measures such as dynamic pricing and time of the day tariffs can help.

Should India then wait before making the big solar plunge, as Swaminathan suggests? Let us look at it from an investment perspective. If solar costs will indeed continue to fall in the next five years anyway, making solar ever more competitive, who would want to invest into new coal based power plants with a life of 30 years? More and more investors are betting on a solar future for India and losing interest in coal and other conventional sources. The enormous SoftBank commitment of $20 bn over 10 years is just one of hundreds of new serious investment prospects in solar.

The main argument for investing later is that solar itself will be even cheaper later. However, India’s power demand needs to be met today already. Also, it is crucial that India learns how to integrate volatile solar power into the grid successfully (we are talking about just over 10% of the power mix by 2022). In the past, India had already missed the first bus on semiconductor manufacturing and we know the result of that. The country should be investing in the technology of the future and not into the technology of the past. Creating a domestic market will also encourage domestic manufacturing and we can already see that happening. We believe that solar has already passed the point of no return in India. The results from the upcoming bids will prove that.

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