At a time of weakness and ongoing uncertainty affecting vast areas of the global economy, China’s independent power producers (IPPs) remain worthy of special sympathy. Not even the prospect of economic growth is likely to bring them much cheer. They must buy a raw material – coal – subject to market-driven price fluctuations, and with it make a product – electricity – over which they have no real pricing control.
"The business [of IPPs] as a whole is never attractive," said Peter Yao, an analyst with Bank of China International Securities (BOCI). Not only must they contend with being "ripped off" by the grid amid rising coal prices in boom times, he said, but "in a slowdown scenario, they have to constantly, painfully bargain with the grid to take their power."
Yao has a "buy" rating on China Resources Power Holdings (CRP, 0836.HK), one of China’s five largest IPPs.
Good management
The seeming contradiction between pessimism regarding the power sector overall and relative optimism focused on specific firms is not uncommon among sector analysts. CRP in particular has drawn favor. Its secret is not a hidden stash of cheap coal or a revolutionary new power source, but good old-fashioned business sense.
In a report on the company last year, Citi analysts Pierre Lau and Maggie Mok highlighted CRP’s strong cost control – it links bonuses, promotion and demotion with plant performance, and pays close attention to maintaining good relationships with suppliers – as a factor influencing their decision to maintain a "buy" rating on stock. Analysts say the company’s aggressive cost management continues to set it apart, with even construction costs 15% lower than those of its peers.
Cost management comes together with a more conservative attitude toward taking on debt. "Some IPPs have 300-400% gearing. That’s terrible," said Dave Dai, an analyst with CLSA in Hong Kong. According to the CRP’s 2009 interim annual report, it had a gearing of 124.2% at the end of June 2009. The firm declined to comment for this article.
The issue of debt ratios is likely to reach a critical point in 2010 as Beijing ponders a gradual shift in monetary policy. While the central government has made clear that it intends to maintain a relatively loose monetary policy for now, tightening measures such as higher interest rates may come later in the year. This would hurt any IPP with a high gearing.
Of the five largest IPPs, Datang Power (601991.SH, 0991.HK) is the worst offender, its debt ratio reaching 445% at the end of June 2009.
Power companies have a number of options for easing their burdens. These include refinancing short-term debt (which may come easily, given the big five IPPs’ state parentage and the political necessity of reliable power generation), direct subsidies and fixed-rate bond issues. Some IPPs have already experimented with bonds and BOCI’s Yao believes offshore-listed players like CRP hold an advantage – they have access to much lower rates than are typically available through onshore financing.
A longer-term solution for CRP and other IPPs will require them to assume more direct control of their supply chains. Taking advantage of government efforts to consolidate the coal mining sector for efficiency and safety reasons, CRP has been aggressively buying up mines to secure access to a steady supply of coal while saving it from the vagaries of market pricing.
"The investment will increase its coal reserve and give it more negotiating power with coal suppliers," said Kevin Au, a power industry analyst with Philip Capital. "The consolidation represents a significant investment for CRP [but] it will begin to see benefits in late 2010."
Analysts say an active approach like CRP’s to controlling costs will serve power producers well, especially amid continued dithering from Beijing on tariff reform. Companies waiting for tariffs to increase in line with rising coal prices – as the National Development and Reform Commission intended with the introduction of tariff-linking mechanisms in 2004 – will likely be disappointed.
In a recent report for Macquarie, analyst Carol Cao noted that even if the tariff-linking mechanisms operate as intended, IPPs would be expected to bear 30% of fuel cost increases this year.
Slow progress
Gradual reform, whereby on-grid and end-user tariffs are relaxed while transmission and distribution comes under closer control, would boost the IPPs’ businesses while helping to increase overall transparency, said BOCI’s Yao. But while the sector has taken some minor steps, including allowing large industrial users to sign power purchase agreements with IPPs, there is a long way to go.
"The move from the current model to the ideal model is a very time-consuming and painstaking process," Yao said.
