Gautam Bhandari, Managing Director and Head of Asia, Morgan Stanley Infrastructure

Hydropower as a sector in India is quite interesting. Despite the potential, it has not progressed, as far as say, thermal power which has done really well with private sector involvement and NTPC's participation.

Hydropower is attractive owing to its ability to meet the peak power deficit. It is renewable and clean power. All power requires some element of compromise and as a commercially viable technology, hydropower is the only renewable energy which is viable without any large subsidy from anyone, be it government or the taxpayer.

There are other benefits of hydropower as well. Thermal power (coal based power or gas based power) is generally base load power, which is required to be stable in the grid. It is not easy to run a grid as the demand for power in the country is not constant throughout the year, or in fact, throughout the day.

For example in the Northern Grid, the peak load power deficit of 17 percent is extremely high. With spikes in power demand, power utilities have no choice but to enforce blackouts to parts of the grid. However, hydropower can meet this deficit. We have a sector that is underinvested and very much capable of satisfying a very fundamental demand - the peak load demand.

For a country that is energy deficient in both gas and oil, hydropower is the answer. Hydropower projects are stable and once up and running, there are no fuel supply issues. They can be run by a handful of people. The turbines used in these projects last for a long time. There are examples of hydropower projects in Canada that have been running for more than 70 years. Electricity produced by hydropower costs a fraction of other sources of power including other forms of renewable energy - wind or solar. When we are producing solar power at a cost of Rs 10-12 per unit, it behooves us to look at hydropower which can be produced at a much lower cost sustainably and has a very low carbon footprint.

Hydro projects are hard to build. Various clearances alone take about three to four years. Involvement of multiple agencies in providing clearances makes it a long-drawn process. In addition, once you start construction you have to face the challenge of working in hard terrain, unmotorable roads, etc. There are states which are blessed with large hydro resources, but the potential is yet to be fully developed due to tough terrain and lack of supporting infrastructure. Uttaranchal and Arunachal Pradesh are two such states. In Uttaranchal, only 17 percent of the available hydro resources have been developed. In Arunachal Pradesh as much as 90 percent of the hydro resources need to be developed.

One of the biggest challenges is the profile of these projects. Investors have to bear the risk posed by uncertain geology and tunneling hazards. Hydropower projects require huge capital investments upfront; so no surprise that the government dominates them. Also, private sector is relatively young and only a few companies are developing hydro projects. As power is a state subject, it is cumbersome to get approval for projects as both central and the state governments are involved.

Hydropower can be divided into two main categories. The first one involves building a large dam on a river and storing a large amount of water. Now, this does involve large-scale displacement of people. In such cases, the debate involves irrigation and power benefits against rehabilitation and financial costs of carrying out those projects.

The projects that we are interested in are run- of- the- river projects which are cleanest form of generating hydropower. In such projects, the original flow of water is largely maintained with a small diversion through a tunnel while not disturbing the surroundings. Water after passing through this tunnel in the mountain is made to drop on a turbine and is then returned back to the river.

Typical run-of-the-river hydropower projects are established in remote regions with low inhabitation and fewer than 100 odd families typically get displaced. A typical run-of-the-river hydropower plant could be anything between 5MW to 1,000MW plus.

The hydropower project at Teesta III being developed by Asian Genco, is 1,200MW. Teesta III involved minimal displacement of people and has had a low impact on the surrounding local environment. Teesta III is in advanced stages of construction. Once commissioned in 2012, it will provide peaking power to the Northern Grid.

Currently, small-hydro is defined as plants that generate less than 25MW. Private sector presence in small-hydro so far has been fragmented. We have individuals, cooperatives and business houses that have one or two hydro projects. Whereas in China there are almost 3,000 of these small-hydropower plants. We ourselves have invested in a portfolio of approximately 24 plants in China. The portfolio has hydro projects ranging from 6MW to 60MW. For promoting smaller hydropower projects, we need to increase the tariff for them. Today, tariff for a lot of small-hydro projects is lower than wind. We need to question ourselves why as a nation we are discriminating between different forms of energy. When you put a wind turbine, it is an easier project where the wind farm can be guaranteed to be operational in 6 to 12 months and thus you have easy access to finance. It's harder for a hydropower developer to go and convince a bank for financing his project, and rarely can a project be built in 6 to 12 months. In short, there is a higher risk in developing hydropower and the government must compensate people to take this risk for providing clean power.

No concession or subsidies have been extended to hydro unlike wind or solar, other than to some small hydro projects. In hydropower, the tariff is determined by two methods. One is through competitive bidding process. Essentially, through this process, you quote how much power you are going to give to the government. Other projects are done on cost plus basis where you have the cost verified by Central Electricity Regulatory Commission. Once the project is completed, the developer is allowed a certain rate of return on the cost incurred. This rate of return currently stands at 15.5 percent. Another half percent is given to you if you build on time, which is highly unlikely, so effectively the rate of return stands at 15.5 percent. In hydro, the quality of developer is very critical. There have been cases where developers with as many as six concessions have sat on projects for years without any progress. In such cases, the government should proactively re-tender the project.

At the face of it, the whole thing looks terrible with a person taking up a site and then trading it off for a profit. There could also be a case where the government is unable to take the site back due to various legal challenges wherein the developer says that the government never gave the environmental clearances required for the project to take off. Such a situation could result into a logjam with neither of the parties yielding to other resulting in long-drawn legal processes. Here, the sale to a credible buyer who can construct the project may be the practical and optimal solution. National Highways Authority of India does a wonderful job in road projects as it gives you a concession, appointment date and gets the necessary clearances leading to hassle free financial closures of the projects. With all these enablers, there is no reason why a developer would complain for not being able to finish the project on time. So, we need not look too far for solutions, we must adopt something that another government agency is doing.

Two types of financing are available for hydro. One is the equity and the other is debt financing. For debt financing, the rates floated by banks are as high as 13 to 14 percent.

Many multilateral agencies also fund hydropower projects but unfortunately they only give financing largely to government or government backed companies. So, they are actually extending funding to companies, agencies and sector, which do not require it. Private players do not have access to preferential financing.

As far as equity financing is concerned, majority of it comes from people's internal accruals. Equity financing at times also comes from individuals, factories, private equity funds or business houses. There are investors who have invested in funds. International Finance Corporation is one such investor. However, the critical mass is not there. We have a low hanging fruit, but the process at the moment is cumbersome. The private sector is not organized enough to get into it.

There are three elements which play a crucial role in determining the success of hydro projects. Hydro projects present greater risk. If one does good investigative work, one can minimise the risk involved, but one cannot fully omit risks confronted in the form of uncertain geology.

Another element that is crucial in executing hydro projects is availability of world-class skill set and high quality equipment. Organisations such as NHPC have excellent engineering talent and thanks to our liberalisation policy, it is easier to import equipment.

The third element is the regulator's role. You need a regulator, who is empathetic towards hydro. The regulator has to take due recognition of what goes on during the construction phase and the huge negative impact for a developer if he goes over budget or over time due to no fault of his, but due to unexpected challenges such as tougher geology. Hydro needs to be looked at favourably in terms of cost incurred based on which one could get an approved rate of return. The way to jumpstart most industries is to have early success stories. Once you have a couple of big success stories, then dozens more people will follow in the footsteps, and thereafter, you can tighten your pricing and other policy framework.

Even with given constraints, hydro will still turn out to be the most cost effective power and its cost would go down further over the years. I believe this is the part that the government and the regulator and marketer do not fully appreciate. Hydro is a sector where you can get fuel independence as a strategic priority for the country.

There is a valid case to be made for faster clearances for hydro projects. India will never achieve its target by pursuing 20MW projects. We will have to focus on bigger projects. There is a need for a strong policy push to include hydro as a part of our energy mix. The current proportion of hydropower of 22 percent in the total installed capacity is not the right percentage for hydropower in a country which is highly blessed with hydro resources. There is an urgent need to develop and strengthen basic infrastructure for facilitating easy movement of men and material on difficult terrain. Far eastern or hilly regions in India need to be connected. At the same time, it will be incorrect to say that all of the country's hydropower projects are in far remote reaches, so we need to maximise our available resources. Secondly, when you look at the interest rate that you get for financing hydro project, it's no different from the one you get for thermal and coal and it's not reflective of the benefits involved in pursuing hydro.

It could be possible on account of prevalent perception of hydro not being clean energy. But we must remember all hydro is not the same. As a nation you have choices, an extreme choice is to have no new power and live green or the other extreme choice is to have the most polluting power industry. I believe government is trying to strike a balance and hydropower has a vital role in striking a balance of sustainable, clean energy.

Because of one reason or the other, many hydropower projects have missed their schedules. However, private companies have proved that they can build hydropower projects within schedule with the top class engineering talent that we have in the country. Once this aspect of the business is highlighted, I believe more investors will turn to hydropower. Private players such as Jaypee, Asian Genco and Bhilwara Energy are doing a good job. There is no doubt that NHPC will always have the mandate and get to have good project, and easy access to funds. If we look at how much private sector has built in thermal coal versus hydropower, the statistics are startling. In hydro, less than 1,500MW is under private sector and for coal, the figure is 20,000MW. Today 65 percent of India's power comes from thermal (coal, gas, and diesel) and only 22 percent is from hydro. Thirty years ago, hydro's share in Indian energy basket was 40 percent. We have lost hydropower market share every year since independence.

As an investor, we have specifically singled out hydro for investment. We believe in companies that have a very good mix of hydro and super critical coal. To assess the potential that the sector holds, it is instructive to look at some numbers given out by Planning Commission. The target for hydropower as part of the XII Five-Year Plan has been set at 31,000MW. Out of this, 12,000MW is from private sector, another 12,000MW from central sector and the balance 7,000MW is to be contributed by the state. Planning Commission expects private sector to ramp up its participation in hydro. Since the current installed capacity in hydropower is 37,000MW, so you are looking at almost doubling it in the next five years. Achieving such huge targets is going to be near impossible unless and until we have some fundamental rethinking on our existing policies.