"IMPACT OF TENDER CONDITIONS ON THE PERFORMANCE OF CONTRACTS AND PRICING BY THIRD PARTY TRADERS"
BY
RAHUL BHANDARE
Chairman & Managing Director
Knowledge Infrastructure Systems Pvt. Ltd.
Introduction:
In the international coal business, traders are an integral part of the transaction chain involving producers and consumers, acting as valuable intermediaries with their knowledge of the market and providing substantial value addition. As a matter of fact, without traders the scale of international coal trade would reduce substantially as traders are supposed to play a very significant role in:
a) Scanning and doing the due diligence of markets both on the export side as well as on the import side
b) Settling commercial terms on both sides by bridging risks and payment terms
c) Ensuring physical delivery of coal
d) Structuring payment and supply security mechanisms to suppliers and buyers
Most thermal coal utilisation takes place in power, cement and steel making utilities which are primarily in the hands of large corporations that have well laid out procurement systems, usually by way of tenders or through electronic reverse auctions. Tender conditions vary from country to country as well as from company to company, which impact performance of contracts and pricing by traders as associated risks may change.
My company, Knowledge Infrastructure Systems Pvt. Ltd., is one of the largest importers of steam coal into India. I would like to take this opportunity to share our experience of the Indonesian & Indian markets in handling issues that dictate contract performance and pricing. Contract performance and pricing are two sides of the same coin, and are therefore inter-related to one another.
Various factors including tender conditions impact the performance of contracts and prices;
a) Sanctity of Contracts
A trader is probably the most vulnerable link in the entire transaction chain of a coal sale-purchase contract. He is the interface between the miner/supplier and the end-user. In addition he must, deal with changes in the legal framework and other regulatory issues of both exporting and importing countries, a trader’s ability to perform the contract depends upon the reliability of suppliers and buyers. But, there has been a history of defaults by both suppliers as well as buyers, particularly in 2008 with economic force-majeure conditions suddenly destroying all efforts made to safeguard a non litigious contract. What is worse is that often it is the trader who becomes the catalyst for this non-performance.
Sanctity of contracts is absolutely critical for international trade. Suppliers and Governments should make a conscious effort to correct the image of Indonesia being a `high risk country' for coal supplies. The signing of a contract must reflect the end of negotiations and not the beginning. Failure to adhere to contractual obligations reverberates throughout the international trading and financial community. The perception of unacceptable risks from Indonesian suppliers is increasing due to frequent regulatory changes. Even when there is no change, the miner and more so the trader interprets the law incorrectly and often creates a mythical scenario, thus causing confusion in gauging the correct depth of an already buoyant market. The key to increased trade flows is predictability. Hence, federal as well as state governments in Indonesia should adopt clear procedures for awarding and operating concessions and this would get a strong & positive response in FDI in the mining & energy sector, resulting in increased exports. Unless the sanctity of contracts, predictability and transparency are ensured, the chances of FDI getting an impetus and increased trade flows in the coal sector are not good at all.
Under exceptional circumstances like in the year 2008, our experience has shown that renegotiation - in whatever form - is a way of life in long-term business relationships, especially where both parties depend on a series of continuing performances to maintain a mutually advantageous relationship. A communication channel hence has to remain open at all times – here is where a trader can and must value add. International and recognised legal principles have a tendency to remain - in narrow confines - the right of a party whose participation in a contract becomes ruinous through no fault of its own, but through the collapse of the basic circumstances underlying the transaction. This has a major disruptive effect on the balance of benefits - to seek renegotiation or escape from such contractual commitments is only a natural temptation. The practice of international business, particularly where Asian cultural influences prevail, to recognise relationships is often more important than the precise terms of the contract.
However, under stable conditions, the formality of a sound legal approach would be more sustainable as it reduces uncertainty and chances of opportunistic behaviour. Above all, it is probably the most convenient contractual mechanism to regulate the relationship of economic operators from multi faceted backgrounds.
b) Regulatory differences in various countries
Regulatory environment in various countries is impacting performance of contracts considerably. More so, un-predictability of regulatory regimes is impacting conclusions of long term coal contracts as well as making the investment climate uncertain for the capital intensive power and mining sector. There is an imperative need to realign the regulatory environments in various countries considering the sensitivities of other parties that may usher in cross border investments by power companies in the mining sector and vice versa.
c) Use of different Indices to benchmark prices
Various countries are using different indices for bench-marking coal prices. This paradoxical situation is becoming a major impediment in development of power and coal mining projects as the pricing risks associated with long term coal supplies is making financial closure very difficult. As an example, Indian power prices for imported coal is based on equal weightage to API4 and the New castle Index whereas Indonesian coal exports are based on the Indonesian Coal Index. The different indices may generally move in the same direction but cannot be reflective of absolute true values. Consequently, traders as well as suppliers & buyers will always face an inherent risk while performing such contracts.
Moreover, though not necessarily in the foreseeable future, it would not be prudent to discount the fact that these uncertainties of regulatory environment and price indices would lead to a preference for alternative fuels adding value to reasons not excluding penalisation on unclean fuels like coal for reasons of climate changes.
d) Psuedo Traders
In the last 3-4 years, a majority of the requirement by India’s Public Sector Power Utilities have been routed through other public sector trading houses who, in fact, are only canalising agencies or Psuedo traders. I may mention that till a decade ago a canalising agency was mandatory. However today they are not to be given any preference over private sector traders, leave alone mandatory for coal imports into India. In fact it is this misrepresentation which leads to a misnomer creating an artificial demand thereby completely misleading market economics.
Unfortunately, as we have seen over the past few years, despite large quantities involved, the canalizing trader approached other local Indian traders, through local tenders, to finalize the orders. So there was no development of new sources and virtually no value addition. In fact, the tenders specified that the contracts be on a back-to-back basis with the contract between the end user and canalizing trader! In all this the only addition was the canalizing traders’ fees -- probably 1-2% -- of the total contracted value, not to speak of poor price discovery and supply security.
The cost of fuel is a pass through cost and hence the increased cost of purchase is passed on to the consumer. So a process which is supposed to lead to the efficient utilization of public monies turned out to be a drain, ironically due to collusion between various public sector organisations.
e) Qualification requirements
Public tenders are, at least on paper are supposed to ensure wider participation. To ensure this, tender conditions need to be broad-based and non-discriminatory. However, in the case of some of the larger tenders it was noticed that the qualification requirements for supply experience kept changing every time. We had a paradoxical situation wherein the tendered quantity would decrease but the qualification requirement by way of earlier supplies kept increasing. This led us to ask: was there collusion with the sole aim of restricting competition, thus defeating the very basis of a tender?
Ladies and gentlemen, let me site you an example. In 2007 a State Electricity Generation company in collaboration with a leading financial services company was putting up a 2X800 MW plant. An RFQ was floated for supply of 2 M MT coal annually on a long term basis. The qualification requirement was supply of 4 M MT per year, in any one of the preceding three years. Needless to add, that only canalizing PSUs and the party supplying to the canalizing PSU could qualify. In fact in a reply to a question asked under RIGHT TO INFORMATION ACT prevailing in India – an Act which gives the right to every citizen of India to seek information from any Government Organisation about its functioning and methodologies adopted in following a certain process in an effort to enhance transparency in the Government, one of these canalising agencies has admitted that in their history of importing coal they have had only one qualified supplier.
Quite obviously, the pricing of such tenders reflect restricted competition and needless to add are generally higher.
f) Security deposits
Public tenders generally specify, along with the bid, the submission of security deposits in the form of bank guarantees of a reasonable amount. This is done primarily to keep away non-serious players.
However, tenders of recent times by public utilities through the canalizing traders in India had about US$ 0.75 – 1.0 million as required security deposit for a supply of 10 M MT. But, strangely, the tender released earlier this year saw differential requests depending on the quantity supplied by the bidders in the earlier years, with deposits varying from US $ 15 million to US $ 100 million: a jump of 100 times even though the quantity tendered had increased by only 20 per cent. This was a regressive condition that served to favour an oligopoly if not a monopoly. Besides denying a level playing field, the additional cost of the bank guarantee would have to have been factored in by all bidders into their prices thereby increasing the price quoted and making them uncompetitive apart from costing the exchequer heavily.
g) Specific requirements of quantities
One of the key services of a trader is to provide value-added services. In the case of the coal trade, particularly in India, quite often the trader takes full responsibility for providing end-to-end logistic solutions of delivering coal from the stock pile of the producer to the stock yard of the end user. It becomes imperative, then, that any tender from a utility with multi-location plants, must specify plant-wise quantities to enable the bidder to plan and cost the logistics.
However, we have public tenders routed through some public sector companies who act purely as canalizing traders that refuse to provide such a break-up even for tenders with quantities in excess of 10 M MT. What is more astonishing is that even the discharge ports were not specified leaving the bidders to do their own guess-work. Naturally such guess work comes at a price which is ultimately paid for by the end consumer.
h) Payment terms
Payment terms have an important bearing on the pricing of every tender. Most public utilities in India insist on payments only after receipt of material at their power plant and some even have conditions for payment after 30 days of the coal being delivered. This results in a payment cycle of 60-90 days and with the high interest regime that is typical to India, pushes the prices up by at least 4 - 5%.
There are conditions other than simple payment terms that public tenders impose creating a restrictive environment, some solely with the idea of eliminating competition. The recent tender by India’s largest public sector utility released through a canalizing public sector trader had a strange and unreasonable condition that payment to the successful local bidders shall be payable to their overseas associates or bidders only in USD. On the face of it, it would appear to be an unremarkable condition as the USD is the designated currency for much of the international trade. But, under Indian banking laws, such payments in USD are not permissible by one Indian corporate to another except in the case of ‘International Competitive Bidding’. Moreover, this was a way to place restrictive conditions on those bidders who do not have subsidiaries or associates abroad. I must clarify that this tender was not publicised as an enquiry seeking international competitive bidding.
Additionally, payments to associates have the effect of infringing on the bidder’s commercially sensitive pricing structure and deferred recovery of payments by the bidder from the associate. Significantly, the canalizing trader was receiving payment in local currency from the end user, yet it chose to impose such payment terms, which leads one to question whether there was an ulterior motive behind this condition.
The contract for such tenders need to have elaborate conditions to be incorporated to safeguard the bidder both for recovery and against any potential contractual dispute that may arise at a later stage as the order is on the local bidder but the payment is to a third party. The cost of potential legal uncertainties also needs to be built into the contract price once again pushing up the price for the hapless consumer, all of which was wholly avoidable.
i) Evaluation basis
One of the important conditions of any public tender is a clear explanation of loading of prices and evaluation. This provides the basis for elimination of uncertainties and helps all bidders to work on the elements of cost without ambiguity. Equally it enables the buyer to compare an apple to an apple.
However, the recent tender floated by the canalizing trader for quantities in excess of 10 M MT is an example of how deceptive the evaluation basis can be. The tender calls for supplies on delivery to power plants but the pricing of the bid was limited to a CIF basis to various ports. What is more, there were no details of the breakup of quantities port-wise and the evaluation was based on an arithmetic average of CIF prices quoted for the various ports, without considering local transport costs that were to be paid on actuals. The ports are both on the West Coast and East Coast with a voyage time difference of 2-3 days and consequently a freight difference of $ 2-3 / MT, apart from huge difference in the waiting time for discharge at various ports. It is perfectly feasible for an interested party (possibly with inside information) to quote lower in one coast and higher for the other coast to achieve a lower average, defeating the very purpose of public tender. Since the break-up of quantities were not given, weighted average calculations could not be recommended, leaving the process open to manipulation.
The local transport cost was sizable at 12-16% of the total cost and the evaluation of the tender without the same meant that the end user would never get the most competitive price. Plus arithmetic averaging distorted the final landed cost as the successful bidder could move the material to his preferred port unmindful of the increased local transport costs. In fact this was exactly what happened in the earlier tender finalized by the canalizing agency, wherein the successful bidder brought in the cargo to the West Coast of India and hauled it across India to a power plant in the East Coast, at a huge cost to the end user.
So it is imperative that tender and contract conditions are transparent and unambiguous so that the evaluation basis also remains so until the end and all bidders have clarity. This will lead to elimination of any hidden costs.
j) Risk Mitigation
Indian tenders are normally for short term supplies varying from 6-18 months on a fixed price basis. The payments are normally made in Indian Rupees. However bidders always contract goods in USD. So they are exposed to the twin risk of commodity prices and exchange rate variations. Let me examine them separately.
1. Commodity Prices: Commodity prices across the spectrum have always remained volatile and coal is no exception. In particular the wild swing of 2008 is still fresh in our memories. The end user always prefers a fixed price excepting in cases of copper, oil and other commodities which have well-developed indices. Coal, and in particular Indonesian coal, does not have any reliable index. But fortunately large mine-owning international traders as well mine owners are willing to work on fixed prices for the short term and, coupled with the many financial hedging instruments, it should be possible to cover one’s position with reduced risks. Recent attempts by the public sector trader to base even these short term prices on the Central Electric Regulatory Commission index model are likely to meet with limited success and are unlikely to be followed by others simply because the composition of index has no relevance to Indonesian deliveries and the fact that it was more targeted for project development of Merchant power Plants with a time line of 25-30 years.
2. Exchange rate variation: Currency variations and in particular the exchange rate swings of the USD have been sharp in recent times. Sophisticated banking instruments are available to cover the same in the short term and normally bidders build adequate protection in their prices. My own experience has been that the forward premium quoted at any point of time does not reflect the risk a trader may actually face at the time of execution. One has to decide between fully hedging against short-term contracts at the beginning versus covering positions judiciously at the time of recognition to minimize not only the risk but also the impact on the bottom line of the company due to forex variations at the time of realization.
A better approach would be to identify the component of such variations and link it to the exchange rate so that traders can avoid unnecessarily building up the cost for such risk mitigation. Large projects as well as construction contracts have successfully followed this and there is no reason why the Indian coal trade cannot do the same.
In fact, many Indian private sector companies and even some Public Sector Units follow the practice of designating the CIF component in USD, payable as per the exchange rate prevailing on the date of BL or negotiations and such contracts have worked to the benefit of everybody, without unnecessarily padding up prices.
We have seen the effect of various tender conditions on the performance and pricing of contracts. My American friends always say ‘There are no free lunches’ and I cannot but agree. The next best thing to a free lunch is to at least try to know the exact cost of that lunch!
The conditions of contracts have an undoubted impact on the price since time line and services ultimately get converted to prices. End users have to realize and strike a balance between risk-free contracts and competitive pricing. Standardized and reasonable tender conditions that will serve both the end user and trade will no doubt result in more competitive prices.
Considering the fact that the cost of fuel is a pass through cost in the utilities, Public utilities have a moral responsibility to the public at large to ensure that procurement is effected in the most efficient and cost effective way. This is possible only if additional intermediaries who do not add value are eliminated and if a professional approach to contracting based on best international practices is adopted. Traders not intermediaries are the need of the day. Unfortunately, recent tenders by India’s largest public utility as well as by most state electricity boards were canalized through a public sector trading company resulting in addition of cost with no corresponding value addition.
Public sector intermediaries through a series of distorted tender conditions ensured that all competition was eliminated with the same party qualifying year after year with obvious ramifications. The cost discovery through such tenders was glaringly higher compared to the prices achieved by open competitive bidding.
Ladies and gentlemen, I am pleased to inform you that my company, Knowledge Infrastructure Systems Pvt. Ltd. finally acted as a whistle blower to expose this nexus and the Government of India has finally started taking cognizance of such unhealthy trade practices. This is our effort to create a healthier and hopefully a non corrupt business environment. After all energy cannot come at the cost of a rice bowl especially in a country like India. It is expected that future tenders will be handled by the end users providing a greater level playing field to all the participants. Corruption has to end to allow markets to mature.
Considering that public utilities in India are the dominant consumers and drivers of the coal import trade there is no reason why they cannot collaborate with each other to adopt a common basis for the trade that can go a long way in eliminating ambiguities and biases and ensuring the best possible price discovery every time they come to the market.
Sanctity of Contracts, transparency & predictability in terms and conditions will bring stability to the market, encouraging new participants to step in and help develop a healthy competitive environment, benefitting all players.
The trader therefore has not only to keep pace with the buoyant market but at all times gauge it’s correct depth to be in tune with a true representation of the demand-supply scenario.
Prophets have predicted a new face for this planet in 2012, today’s pundits predict economic revival and vibrancy around the same time. I believe that a good trader is here to stay, value add and benefit in either case.
THANK YOU, TERI MA KASI BANYAK.
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