UP Power Corporation Bonds Review and Should you Invest in UPPCL Bonds?

In the month of March 2022, it was announced by the UP State government that they are reviving their plans to raise INR 8,000 crores for U P Power Corporation Limited (UPPCL) by issuing bonds in the Primary market. Since then, UPPCL has raised INR 493 crores in March 2022 and INR 436 crores in October 2022 in the form of NCDs.

The government of Uttar Pradesh guarantees these bonds, and the additional support is provided by the trustee-administered escrow and payment mechanism.

These bonds are called State guaranteed bonds or SGBs. However, they are riskier than State development loans (SDLs) and Government bonds.

UP Power Corporation Ltd (UPPCL) is offering bonds for investment. Learn more about the details of the UPPCL bond offering and consider whether it is a good investment opportunity for you.

But first, let’s understand UP Power Corporation Limited. It is a UP State Government-owned electricity distribution company (Discom) which is engaged in the business of transmission and distribution of power within the state.

UPPCL was formed on January 14, 2000, by unbundling the Uttar Pradesh State Electricity Board into three separate entities: 

1. UPPCL, holding the transmission and distribution business; 
2. Uttar Pradesh Rajya Vidyut Utpadan Nigam Ltd houses thermal generation; and 
3. Uttar Pradesh Jal Vidyut Nigam Ltd, which holds the hydro generation business. 

The transmission business was subsequently carved out of UPPCL into an independent government company in 2007, Uttar Pradesh Power Transmission Company Ltd.

One can wonder what the difference is between Transmission and Distribution. The transmission lines operate at high voltages, and they are used to transmit the power from the generating station to the substations, whereas distribution lines operate at low voltages and transport electric power from substations to the consumer’s loads.

That means the electricity we are consuming in our households is being supplied by the distribution companies (Discom)

The five Subsidiaries or the Discoms under UPPCL include the following:- 

1. Dakshinanchal Vidyut Vitran Nigam Ltd (Agra discom) 
2. Madhyanchal Vidyut Vitran Nigam Ltd (Lucknow discom)
3. Purvanchal Vidyut Vitran Nigam Ltd (Varanasi discom) 
4. Paschimanchal Vidyut Vitran Nigam Ltd (Meerut discom)
5. Kanpur Electricity Supply Company.

*Southern-Up Power Transmission Company Limited was one more subsidiary. It has now been stricken off)

Understanding the Business of the U P Power Corporation Limited:- 

We now know about UPPCL; let’s understand the business model of this company. These companies earn their revenue by charging tariffs to household, commercial or industrial customers.

These tariffs are generally decided by the state governments. UPPCL purchase the power from the production companies.

Generally, all the electricity distribution companies of states in India are making huge losses. However, the state governments provide subsidies and guarantees on the loans of these companies.

However, most of these companies work for the public good, and the performance of these companies is measured by AT&C Losses and the ACS-ARR gap.

Let us also understand two important terms that are being used to measure the performance of these companies: –

Read More: Best Energy Sector Mutual Funds to Invest in 2022

Aggregate Technical and Commercial (AT&C) losses:-

The concept of Aggregate Technical & Commercial losses provides a realistic picture of the loss situation in the context it is measured. It is a combination of energy loss (Technical loss + Theft + inefficiency in billing)& commercial loss (Default in payment + inefficiency in the collection)

It is calculated as below:- 

AT&C Losses = {1 – (Billing Efficiency X Collection Efficiency)} X 100

The gap in average cost of supply and average revenue requirement (ACS-ARR): –

This is calculated on a per Kilowatt hour basis by deducting the Total expenditure from the revenue received from the sale of power, including the subsidy received. 

The AT&C (aggregate technical and commercial) loss remained high at 31.3% and 27.2% in the first half of fiscal 2022 and fiscal 2021, respectively, similar to 30.4% in fiscal 2020. The gap in average cost of supply and average revenue requirement (ACS-ARR) continues to be high at Rs 0.98 per kilowatt hour (kWh) and 0.94 per kWh in the first half of fiscal 2022 and fiscal 2021 respectively, compared with Rs 0.34 per kWh in fiscal 2020 mainly due to lower revenue realisation, adverse customer mix and higher power purchase expenses.

However, the Central government has approved the Revamped Distribution Sector Scheme, a Reforms-based and Results-linked Scheme with a five-year budget of INR 3,03,758 Crore, to improve the quality, reliability, and affordability of power supply to consumers through a financially sustainable and operationally efficient distribution sector.

The key objective of the scheme is to reduce AT& C losses to 12-15 per cent across India, and the ACS-ARR gap to zero, by increasing operational efficiencies and financial sustainability of all DISCOMs/Power Departments, excluding private sector DISCOM.

Under the above scheme and Atmanirbhar Bharat package, the UPPCL is expected to get government subsidy and government department receivables over the next nine years and three years, respectively which shall improve the accrual.

Financials of UPPCL:- 

As you see in the above table, it is difficult to make decisions purely on the basis of the financials of the company as it is loss-making.

The entity made a profit in FY 2021 only because of the reversal of provision made on impairment of investments to the tune of INR 17,111.68 crores. If we exclude this amount, the entity still would be in losses.

The unsupported rating by the CRISIL (without the guarantee of UP govt and escrow mechanism) of the company is BB which is lower than the investment grade or can be termed a junk rating.

However, the rating with the support of a guarantee is given at A+ by CRISIL.

Existing issuance of the UPPCL:- 

Following are the recent bond issuance of the issuer available in the secondary market. These bonds were issued on private placement with a ticket size of INR 10,00,000. However, these bonds are not frequently traded in the secondary market. So, Liquidity is not assured because of the higher ticket size.

Key Features of the Proposed Bond Issuance of INR 8,000 crores:- 

• The non-convertible debentures will have Quarterly interest.
• The tenure will be 10 years.
• Upfront creation of liquidity facility in the form of a DSRA for the next two-quarters of principal and interest payments (in the form of cash); additional DSRA augmentation within 15 days after the end of the seventh and eighth quarters to take care of the enhanced servicing requirement towards principal repayments
• Standing instruction from one collection account (or designated receipt account) of the borrower with an average daily inflow of at least Rs 9 crore for daily transfer into the bond servicing account. This account will be free from any encumbrance or escrow towards any current or future lenders or creditors
• Funding support for servicing of the bonds by way of requisite fund infusion from the GoUP in the default escrow account any time between 45 and 15 days prior to every quarterly bond servicing date; the requisite funds would be immediately transferred to the bond servicing account on the next working day.
• If the DSRA is dipped into, the default escrow on the UPPCL state government funding receipt account will get activated, and all funds received in this account would be trapped and first used to top up the DSRA.

Should you invest in these Bonds:- 

These bonds come with various types of risks. Some of the main risks have been mentioned below:- 

1. Credit Risk: –Credit risk is the risk of financial loss to the Company if a customer or counterparty to a financial instrument fails to meet its contractual obligation resulting in financial loss to the Company. Credit risk is mitigated by the guarantee provided by the Government of Uttar Pradesh and the escrow mechanism for repayments.
2. Interest Rate Risk:- Bond Prices and Interest rates are inversely proportional. So if the interest rate in the economy rises, it may impact the yield of the bonds.
3. Liquidity Risk: – These bonds have higher ticket sizes and usually have liquidity due to infrequent trades in the secondary market. 

It is to be noted that though the unsupported rating of the company is CRISIL BB, the bonds issued are guaranteed by the UP Government and have adequate liquidity measures in the structure.  However, one should read all the financial documents and should, understand the risk involved, and then make an informed decision on whether to invest in these instruments. 

Historically, we have seen default even by state-owned companies.
The Power production or transmission companies, due to their huge losses, generally default in the repayment to Power Finance Corporation.
There are instances of delay in interest payment of the State Guaranteed bonds (SGBs) as well. State-guaranteed bonds issued by Andhra Pradesh Power Finance Corporation Limited are in default as there are instances of delay in interest and principal repayment on the rated bonds. The timeliness of meeting obligations remains uncertain until there is a final resolution on the distribution of assets and liabilities between the states of Andhra Pradesh (AP) and Telangana.
The rating rationale link and news article link have been attached below for reader’s reference: –
CRISIL Rating Rationale

ICRA Rating Rationale

News Article

In the case of Andhra Pradesh Power Corporation, what was observed is that the Debenture Trustee failed to invoke the guarantee of the State Government. So, the recovery is uncertain in these bonds. Madhya Pradesh, Uttar Pradesh, Bihar, Punjab, and Orissa state PSU bonds also defaulted during 2000-2002.
These bonds, however, have been restructured and subsequently honored, but the likelihood of defaults occurring again should not be ignored, even if the possibility of default is low.

Conclusion
Public welfare-oriented companies, which are primarily government-owned, may incur losses and deficits. To maintain their operations, they receive financial assistance from the government or borrow through term loans or debentures in the capital markets. It is crucial to evaluate the financial stability of the State and the State-owned companies to make an informed decision. To be noted that just because there is a state guarantee it does not mean that these are risk-free bonds. As we have seen in the article above, there have been instances where even state-guaranteed bonds have defaulted. Additionally, understanding the repayment structure’s escrow mechanism is important to ensure the timely repayment of obligations.