Application of the insolvency code to the electricity distribution sector
Recently, the Union Energy Ministry claimed that state-owned electricity distribution companies (discoms) fall under the Insolvency and Bankruptcy Code (IBC). The ministry believes that if such an entity were to default on its payments, it could be admitted to the corporate insolvency resolution process under the Code. However, the resolution of these discoms raises many complex questions.
A business is said to be insolvent if it is unable to make the payments due, such as paying off a debt or making a payment to a supplier. Insolvency is an indicator that there is something wrong with the business model of the company or its financial structure. If its business model is satisfactory, the insolvent business can become profitable if it undergoes financial restructuring. This process, called resolution, can involve a new party taking over and running the business, and creditors taking a “haircut”. The socially desirable outcome in this case is that the losses should be fairly distributed, the economic value of the business should be preserved, and the business should remain in business. If the business model itself is flawed, financial restructuring cannot help. In this case, the desirable outcome is for the business to be liquidated, for the remaining physical and financial assets of the business to be liquidated, and for the proceeds to be fairly distributed among its creditors.
This is the process mandated by the IBC, and which, according to the Ministry of Power, is now applicable to discos. Most state-owned nightclubs have suffered heavy losses and need continued support from state governments in the form of grants, loans and guarantees. After the Covid epidemic, the Union government announced liquidity assistance of ??90,000 crore, which was later improved. Despite all this support, the total net worth of state-owned nightclubs is approximately negative. ??62,000 crores.
If discoms are allowed into the resolution process under the supervision of the National Company Law Tribunal (NCLT), this could provide an opportunity for the state government, if it wishes, to leave a private party (whoever succeeds in the resolution process) take on the disco. The discom would come out of the resolution process with a sustainable financial structure. The state government will not have to sustain the dysfunction on an ongoing basis, freeing up valuable fiscal space that it can devote to education, health, or other priorities.
But the application of the IBC process to discoms is not trivial, because discoms have several characteristics that set them apart from other companies. Nightclubs are monopolies that provide an essential service, electricity. Therefore, it is important that even if the business is subject to insolvency proceedings, there is no disruption in the electricity supply to customers. There are also many other uncertainties in the process, such as whether the new private party will need a new distribution license, how the NCLT and the state electricity regulatory commission, two quasi-judicial bodies, can avoid stepping on each other’s toes, and what if the resolution process fails. As mentioned above, the usual process is to liquidate the bankrupt business, but this route may not be feasible in the event of a discomfort.
The discom can be seen as a combination of two activities: the network operator activity (operation and maintenance of the distribution network) and the supply activity (purchase of electricity from producers and sale to retail customers). Network activity is a largely risk-free regulated activity, and as such, it is not a loss-making activity. Most of the staff of distribution companies are recruited for network activities. Before any change of management, it would be necessary to put the existing staff in confidence and to provide assurances regarding their conditions of employment.
The supply sector is where losses in the electricity sector are parked. One of the reasons is the exercise of monopoly powers in signing long-term power purchase contracts, either at higher cost or in excess of need. The resolution process can help the discom to renegotiate such agreements under the supervision of the NCLT. Another reason for the losses is the inability of state governments to pay for their electricity consumption or subsidized consumption. A mechanism is needed to guarantee the private party that it will be able to realize the claims of state governments.
Thus, it is necessary to separate the network activity and the electricity supply activity. Network activity may continue to be a monopoly due to the physical constraints of laying several power lines under limited influence. To prevent monopoly price gouging, strict regulation of network business operating expenses will be necessary. But in the supply sector, monopoly can be removed and consumer choice can be brought about by allowing supply competition. If this is not done, the nightclub will become a private monopoly, which could lead to higher electricity prices and conflict with the state government.
Successful resolution of discoms can only happen if the state government itself takes the initiative. Nightclubs are highly regulated entities. Unless the state government is able to give confidence to private parties through a favorable political environment and through confidence that the state regulator is independent, no private party would be willing to take control. of state dysfunction.
To sum up, while the IBC process may theoretically be applicable to state-owned nightclubs, its practical applicability will depend on unraveling the intersecting web of political uncertainties. The IBC can be a sure way to move the industry towards more efficient management, provided that the network activity and the provisioning activity are unbundled and the supply competition is introduced. The recent Electricity Amendment Bill contains enabling provisions for such competition, but the successful resolution of detained Discoms depends primarily on the ability of the state government to create an enabling policy environment.
(Prasanth Regy, consultant, secretary of NITI Aayog & Srikant Nagulapalli, energy department, government of Andhra Pradesh)