Indian Energy Exchange — An Analysis

Indian Energy Exchange (“IEX”) is the biggest energy exchange in India which facilitates trading of electricity and energy certificates. The Company was incorporated in the year 2008 with an aim to enable price discovery, transparency and accessibility in the Indian power market.

The Company was originally incorporated by Financial Technologies Limited who was forced to sell its entire stake of IEX in 2015 after the NSEL debacle. It is currently owned by various institutions, private equity players, hedge funds and is professionally run.

Users-

1. Power Generation companies
2. Distribution companies
3. Industrial consumers.

The Need for a power exchange-

In India, power demand and supply is extremely dynamic based on the time of day, the season etc. All through the year certain parts of the country are producing excess electricity whereas other parts are in deficit. Further, the cost of production may be lower in certain states.

IEX is beneficial to all the participants in the electricity supply chain by allowing power generators and distribution/transmission companies to streamline their operations by providing a fair and transparent market price and also allows them to adjust to the dynamic nature of supply and demand in the power market. Also, the prices offered on the exchanges are considerably lower than other options.

IEX currently only operates in the very short term power market (upto 11 days). Only 13% of power is procured from short term markets in India (Power exchanges constitute around 4%). The remaining is obtained through legacy long term Power Purchase Agreements (PPA) (>7 years).

Discoms have to honor their old PPAs and obtain base demand from the Generation Companies at the contracted price which were fixed years ago and are substantially higher when compared to current exchange prices. For any demand in excess of the contracted amount, they have to look at the short term power market.

The options in the short term power market are-

1. Power exchanges- The regulator is in favor of strengthening the exchange mechanism for trading power to ensure price discovery. Various states charge an extra fee to the buyers for access to the grid which may make transactions on the exchange unviable above a certain price.
2. Bilateral contracts and Deviation Settlement mechanism- is a mechanism by which power is procured by paying a penalty. A bilateral contract is entered into for this purpose. Even though this is meant to be used only as a last resort, market participants have been using it for real time procurement. To discourage this, the regulator has stated that the DSM has to be linked the closing price on the exchange. This is expected to shift demand to the exchanges as the prices would anyway be based on the exchange price and exchanges offer better transparency, liquidity and ensure payment/delivery. Also, with the increased liquidity in power exchanges, Discoms increasingly prefer exchanges over other short term mechanisms.

Further, with excess power supply leading to a fall in market prices and with the availability of various products on the electricity exchanges, the period, price and base volume of PPAs are in decline.

Also, as per the Paris climate agreement, India will have to ensure that non-renewable energy makes up at least 40% of the energy production in the country, by 2030. Non-renewable energy is unreliable and the generation varies on a daily basis. There can be periods of excess and lower generation. Therefore, this would also require a strong power exchange to adapt to the shifting trends of power generation.

Products offered by IEX-

1. Day Ahead Market (DAM)- DAM is their premium product comprising 90% of their volume. As the name suggests, it allows participants to buy/sell electricity for the succeeding day.
2. Term Ahead Market (TAM)- TAM allows participants to trade electricity for a period upto 11 days via intraday, daily and weekly contracts. Although this market does not contribute significantly to their topline has started gaining traction recently and seen significant growth in FY 19–20.
3. Renewable Energy Certificates (REC)/Energy Saving Certificates(ESCert)- IEX has a 75% market share in the trading of RECs and ESCerts.

Business Model-

IEX’s revenue consists of –

1. Transaction Fees- Comprises of ~80% of Total Income and is directly correlated to the volumes traded on the exchange.
2. Membership Fees- is an annual fee paid as membership to be allowed to trade on the exchange. This comprises of 6–7% of Total Income.
3. Other Income- Comprises ~13–14% of Total Income and is mainly on account of Income on cash/investments held by the Company.

As the revenue is directly correlated to the volume traded on the exchange, let’s have a look at it-

Total Volume traded on the exchange has grown from 2616 MU in FY 2009 to 52168 MU in FY 2019–20. DAM, their flagship product has been consistently growing in line with increasing power consumption and market share gains. TAM has started to grain traction in the past few quarters and is becoming increasingly popular, especially in the intraday market.

Products in the pipeline-

1. Real Time Market- This would enable trading of power for delivery within 1 hour. A vibrant Real Time market will ensure that PPAs are only entered for base demand enable buyers/sellers to take advantage of market prices. It is important to note that the regulations for the Real Time Market sets aside 90% of the transmission capacity for the biggest power exchange (which is IEX). Therefore, it is certain that IEX will be leaders in this segment too.
2. Gas Exchange- will be India’s first gas exchange and is expected to launch soon. It will be interesting to see how this plays out. It can potentially be a significant part of IEX.
3. Cross-border trading- is also expected to be launched in FY 20–21 and can increase the volume traded on the exchange.
4. Long duration contracts/ derivatives- A long drawn out court case between SEBI and CERC as to who has regulatory control is on the brink of being resolved. IEX will launch longer duration contracts on obtaining approvals and this will allow participants to hedge their risks thereby increasing liquidity and volume. This can be a game-changer as this could reduce the reliance on longer term PPAs.

Financial strength-

IEX’s revenues like all exchanges depends mainly on transactions which enables it to be asset light and have a high operating leverage. Its costs are fixed and the marginal costs incurred for scaling up are minimal. From the above data, we can clearly infer that-

1. The returns on equity and capital employed are extremely high as the Company does not require significant capital. The major operating costs for the Company are employee costs.
2. Free cash flow is moving in tandem with PAT implying that the Company is able to convert the profits reported, as cash.

As IEX does not require a lot of capital, they have been distributing most of their free cash to their shareholders. Their dividend policy suggests that at least 50% of PAT will be distributed. (they have distributed around 60–70% in the past). Once their expansion is complete, the Company should be able to distribute a higher amount. Also, the Company has cash and equivalents of ~INR 550 Crores on their Balance Sheet, which they can gives them sufficient liquidity to utilize for future product launches.

Valuation-

Instead of attempting to in trying to predict future cash flows, let us rather look at what the market is pricing in-

To be conservative, I have taken cash flows of FY 18–19 as the base year
(INR 135 Crores). While working back with a Margin of Safety of 20%, I find that the market is pricing in 10% growth in the initial 10 years and a terminal growth rate of 3% after that (discounted at 13%), to arrive at the current market price of INR 140/share (as shown below)-

As the above calculations do not consider the effect of the tax rate cut and the volume growth in FY 19–20, the current market price looks reasonably attractive, especially considering the following-

• Network effects inherent in an exchange model which makes it extremely hard to shift volumes away from the leader. This has played out in various exchange markets all over the world wherein the 2nd/3rd player find it impossible to make inroads. Power exchange of India Limited (PXIL), backed by the almighty NSE was incorporated in the same year as IEX. However, IEX has 95–98% share of volumes. Further, regulations in the Real Time Market favour the market leader by blocking 90% of the transmission capacity allocated to exchanges, in favour of the market leader i.e. IEX.
• Increase in electricity consumption per capita due to increasing access and dependence on electricity
• Sector reforms like a reduction in open access charges and opening up electricity derivatives are highly likely given the precarious financial position of the sector
• Shift in electricity generation trends towards renewable energy which is unreliable and difficult to store
• Market share gains from other short term options and an expansion of the short term market as a whole
• IEX is a cash flow machine with low capital requirements and a possible increase in the amount distributed to shareholders (in the form of dividends/buybacks).

One should also note that even during April 2020, when the entire country was shut, the volumes only declined 6.6% year over year and the exchange was working 24/7. This clearly portrays dependence of the market on the exchange and management’s competence.

Key Risks-

1. Regulatory risk- Due to the importance of the energy sector to the country, there exists a possibility of the regulator stepping in to reduce the transaction charges. At present, IEX has to obtain permission from the regulator for any increase in fees.
2. Competition- The government has their own platform for electricity trading called DEEP which predominantly focuses on longer term contracts. However, the volume traded on it is limited and hence, the price is higher. Also, the counterparty risk still exists on the DEEP platform and the platform has not shown any signs of gaining market share. The other existing exchange (PXIL) has not made any dent in the market, even with backing of NSE.
3. New Entrant- BSE along with PTC (who is responsible for 20% of the trades on IEX) have applied for an exchange license. The management has stated that although PTC executes 20% of the trades, it is done on behalf of their clients, who would want to trade on an exchange with the best price and liquidity i.e. IEX.