'12% returns on network sharing offers cushion against competition'

The Petroleum and Natural Gas Regulatory Board's (PNGRB) draft regulations on city gas distribution (CGD) network sharing, if implemented, could reduce uncertainty and encourage companies to enter lucrative markets, domestic rating agency Crisil said on Monday.

The rating agency in a report said that while existing, well-entrenched distributors may see their operating profits sliced, assured and regulated post-tax return on capital employed (RoCE) of 12 per cent for sharing their infrastructure, high headroom in operating margin, strong market position in service areas, and robust balance sheets will help sustain their credit profiles.

At present, distributors in lucrative service areas such as Mumbai, Delhi and Ahmedabad do not have competition despite their marketing exclusivity ending because there is no regulatory framework to determine network tariffs for sharing common infrastructure such as pipelines and compression facilities. The licences for these 'geographical areas' (GAs) were awarded before the PNGRB was established.

The PNGRB's draft regulations propose calculation of network tariff based on the cost of service plus a post -tax RoCE of 12 per cent. The cost of service is defined as operating cost including depreciation, while capital employed is the sum of net fixed assets and normative working capital.

Manish Gupta, Senior Director, CRISIL Ratings, says: "The implementation of these regulations could remove regulatory uncertainty around 37 GAs. We estimate that new entrants may have to pay Rs 6-9 per standard cubic metre (SCM) as network sharing cost to the incumbents. In return, they will be able to compete without significant capital expenditure to lay out the infrastructure."

Competition will increase the most in the CNG segment, which has a lion's share (more than 40 per cent) of overall demand, attractive operating profit margin of 30-35 per cent, and easy access to customers. The low-margin industrial PNG segment could also see an increase in competition because of high volumes, but the domestic PNG segment may not because of low-volume and sticky retail customers, and the significant marketing effort required.

The increase in competition, however, is unlikely to dethrone established players. The tariff on network sharing will give incumbents a sizeable cost advantage over new entrants, almost equivalent to the current operating profit of Rs 7 per SCM. That is in sharp contrast to the sub-Rs 1.5 per SCM bid for new GAs in the past few auction rounds.

The rating agency said that assuming a 20 per cent volume loss to competition along with a 10 per cent price cut, a fifth of the operating profits of existing distributors may be shaved off after adjusting for revenue from network sharing.

Says Naveen Vaidyanathan, Associate Director CRISIL Ratings, "Grabbing market share will not be easy for new entrants, with incumbents enjoying strong market presence, competitive gas sourcing and robust financial positions. Despite the competition, high headroom in margin and depreciated asset base would help players sustain a healthy RoCE of over 20 per cent."

Net-net, implementation of the draft regulations is unlikely to materially impact established city gas companies. Their credit profiles will continue to be supported by strong balance sheets. Their gearing was only 0.2 time at the end of fiscal 2020.

But any significant increase in competitive intensity that forces incumbents to materially reduce their end-user prices would lead to a sharper reduction in operating profit. That will be a monitorable. Pertinently, the draft regulations do not spell out how capacity and operating rates in GAs will be determined, and the quantum of capacity new entrants will be allowed to use. These will bear watching in the final regulations..