Description

Indian Energy Exchange (IEX) is India’s largest energy exchange with 98% market share. With currently less than 4% of India’s energy consumption being traded on the energy exchange, this is a structural growth investment opportunity for the long term. Growth will come from the potential for power exchange traded market to grow in India and the ability for IEX to dominate the industry. 

Energy market in India and trends: 

India has about 356 GW of installed power capacity (3rd largest in the world) with about 1370billion units generated last year. Per capita consumption is at 1200units, which is significantly lower than developed markets. ~78% of energy generated in FY19 was from thermal, ~9% from renewables, ~10% from hydro and 3% from nuclear. Consumption breakdown: 40% for industrial sector, 25% for domestic, 18% agriculture, 9% for commercial. Demand for power has grown at about 7% in the last decade driven by domestic and industrial sectors.

About 89% of the power demand is met by long-term power purchasing agreements (PPAs) and the remaining 11% is purchased in the short-term market. Within the short term market, volumes on the exchanges was about 38%, bilateral (direct and traders) 47%, and DSM 15% of the power consumed last year.   

Energy exchanges are relatively new to India with regulations liberalizing only in the last decade and half. Exchanges provided Discoms with choice to manage real-time demand and also purchase short-term / small capacity requirements at much lower prices than their PPA prices. Currently there is a strong regulatory push from the government for Discoms and interstate transmission companies to source power requirement in the short term market/exchange.  Additionally, the transmission capacity addition in India has now caught up with the power produced, which has led to decline in congestion. Volume congestion was about 15% at its peak in 2015 but since has dropped to below 1% in 2019. Transmission congestion is likely to ease further, as transmission grids strengthen with time, which will benefit the clearing volumes on the exchange and participants confidence.  

About IEX: 

IEX was formed in 2008, and in the last 10 years the company has been able grow volumes traded at 35% cagr, to take 4% market share of the entire power consumed. IEX has 98% market share of the energy exchange. Day Ahead Market (DAM) - where electricity contracts of 15-minute time blocks for the subsequent day are traded – is a key product with 90% of volumes. The other main product is TAM (Term Ahead Market) - offers trading options from intraday up to 11 days. Renewable Energy Certificates (RESs) and Energy Saving Certificates (ESCs) contribute the rest of IEX’s trading revenue. 

Investment thesis: Growth potential for IEX with existing products: 

The growth potential for IEX comes from power demand growth in India, which should at least grow at the rate of GDP of 6-7% for the next decade. Demand growth should technically be much higher than GDP growth due to the low per capita consumption, but one of the key reasons for the slow growth of power demand in India has been the due to the weak financial positions of the state Discoms. These Discoms have been burdened with large operational losses and outstanding debts, because of which they have not been aggressive in purchasing power to meet actual demand.  The situation has been improving slowly due to government initiatives (UDAY and other schemes). The state discom losses have narrowed in the recent years and the trend should continue due to dropping AT&C losses and the procurement of cheaper power from short-term markets like exchanges. 

Separately, the market is moving from LT PPAs to short-term contracts. Discoms are reluctant on signing new LT PPAs with new gencos due to i) their financial situation, ii) difficulty in predicting long term demand, and iii) the availability of cheaper prices on the exchange market. The cost of power available in the short term market was about Rs 3.1 per unit compared to Rs 5.4 per unit on average for discoms under their existing PPAs. Going forward, gencos will look to meet their base demand through LT PPAs and look for short term sources to meet the seasonal variation in demand. 

Additionally, India has been phasing out thermal gencos which are over 25 years old. Currently there is about 40GW of old capacity. Between 2015-2018, India has decommissioned about 6.8 GW and another 4 GW is expected to be decommissioned in the next 1-2 years. These old gencos are under PPAs, and Discoms will most likely look to replace this demand from the short-term market. 

Finally, India has been aggressive in its plans to add renewable energy to its mix. Currently renewables is about 20% of the current capacity and about 10% of the power consumed. India currently has about 75 GW of renewable capacity and the government wants to increase this to 175 GW in about 2 years. While these RE capacities are tied with long-term contracts, they will i) free up existing thermal capacities contracted by the state discoms and ii) cause supply fluctuations which will benefit the volumes on the exchange. 

Investment thesis: Growth potential for IEX from new products: 

IEX has a number of new products that will launch over the next few years which have the potential to increase its market share within the short-term power purchased. 

1. Long term contracts: Long term product will offer contracts beyond the current contracts whereby buyers can purchase their power demand up to 11 days in advance. The regulatory jurisdiction issues around IEX offering these products have been settled and the company expects that they can start the product in Q1 next year. Currently the long dated contracts are purchased via direct or bilateral banking markets. The market size is about 65 billion units or 5% of total power demand and company believes about 8bu can transfer to the exchange in 2 years. 

2. Real time market: currently any over drawl and under-injection gets settled via Deviation Settlement Mechanism (DSM). Volumes crossed through DSM stood at 25BUs in FY19; of these, IEX highlighted that 16-17BUs are towards over drawl and the balance 8-9BUs owing to under-injection. Buyers have been using the DSM for their advantage since the DSM charges have been much lower compared to the market price of power. The regulators have now amended the charges and the arbitrage opportunity has reduced. Regulators are looking at ways to totally eliminate the amount of power cleared through DSM. With the amendment of the DSM charges the arbitrage opportunity goes away and over drawlers will most likely buy power from the exchange. The Company targets 50% of the over drawl market in FY21-22, equivalent to 8-9BUs. CERC has completed public hearings on the draft regulations and is likely to come up with final regulations in the next 1-2 months.

3. Cross border trade: new regulations have opened up opportunities to purchase and sell power through power exchanges from neighbouring countries, such as Nepal, Bangladesh and Bhutan. The opportunity size is relatively small at about 12 billion units and currently there are a few hurdles (enough transmission line infrastructure), which means that the upside is low and will take some time for this to materialize. Management expects that they should be able start trading in the next 3-6monthts. 

4. Derivatives: India currently does offer any products to hedge power prices. Regulators have started discussion on this front. In terms of timing, this might take a few years to launch, but the opportunity size is huge. 

5. Gas Exchange: India currently does not has a gas exchange and the government is also looking into launching one. The product and technology required will be similar to power exchange, and IEX has already been working on this with the regulators. Management is expecting operations to start in 1H of 2020 in a small way. If the product takes off, the opportunity is huge.  

The stock has corrected this year on back on declining volume growth and weak power demand in India, as the economy has slowed down significantly this year. The stock currently trades at about 20x next year’s earnings, which significantly under appreciates the structural upside potential for the company. 

Risks: 

• Regulations: there is massive oversight from regulators in the industry. Any negative regulations including fee reduction can have massive impact on the company’s earnings.    

• Competition from new entrants: currently 1-2 more companies are looking to launch power exchanges. 

• Lower volume growth on exchange. This year the stock has underperformed due to the low trade volume on the exchange. For 1H FY20, volume was down 2% yoy compared to 4% volume growth for the industry. In the short and medium term there would be volatility in the volumes traded for various reasons. 

Catalyst

volume pick up; new product launches