Return expectations coming down

22 February 2022 |

Soaring costs and aggressive competition for new projects have made it a tough time for project development business. Module costs have edged down from the exceptional highs of around USD cents 0.30 in November to USD cents 0.27 but are still up about 16% over prices a year ago. Shipping freight rates, aluminum, copper and steel prices are also relentlessly firm. Total solar EPC cost, excluding safeguard duty, is up 18% YOY at INR 32.62/ Wp. As against this, tariffs for SECI offtake projects have increased by only 9% YOY for projects in Rajasthan.

  • Rupee debt funding cost has fallen to all-time low of 7.50-8.50% for high quality renewable projects;
  • Squeezed between rising costs and strong competition, project developers have reduced their return expectations;
  • Construction and financing cost risks are getting underpriced in the process;

Imposition of BCD from April onwards is going to be another financial challenge for projects where there is no clear formula for change in law compensation. Then there is the issue of project delays and/ or additional cost of adding bird diverters to transmission lines in protected areas in Rajasthan and Gujarat as per the Supreme Court order.

Figure: Auction tariffs vs EPC cost for solar projects

Source: BRIDGE TO INDIA research

Against this backdrop, fall in lending rates by government-owned institutions, Power Finance Corporation (PFC) and Rural Electrification Corporation (REC), has come as a major relief. The two institutions announced a 40 bp reduction in January for lending to renewable projects. Together with some public sector banks, they are providing up to 20-year funds at an all-in cost of around 8.50% and 3-5 year funds at a fixed cost of around 7.5%. This is probably the cheapest cost project finance debt seen in the last ten years.

Fall in debt cost has allowed developers to improve effective leverage to well over 80% for operational projects and relieved pressure on equity returns. Investor return expectations have also come down. In particular, PSU developers like NTPC, SJVN and NHPC are operating with equity returns of about 10% for greenfield projects. Some other quasi-sovereign developers and international utilities too have reduced their return expectations to around 11-12%. Other developers, accounting for about one half of the project development business, have no choice but to accept the market reality.

For operational projects with SECI offtake and ISTS-connectivity (quasi-sovereign offtake, no construction risk, no curtailment risk), 11-12% return – implying a risk premium of about 5% for long-term government debt – could be argued to be reasonable on a risk-adjusted basis. On the other end of risk matrix, for unbuilt projects with offtake by poorly rated DISCOMs (Tamil Nadu, Uttar Pradesh, Haryana and Bihar, for example) and state transmission connectivity, return expectations would be much higher at about 18%.

The trouble is that there is no buffer available in these return levels for the substantial construction price and time risk. Second, almost inevitably, debt market rates would go up as central banks start tightening monetary policy in response to rising inflation and growth. If EPC cost comes down by about 15% in the next 12 months, most of the pipeline projects bid at around INR 2.20/ kWh would be viable. Otherwise, as seen with the 600 MW Acme-Scatec project, many of these projects risk being shelved.  


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