Wednesday, January 22, 2014

1st Floor, P&O Plaza, I.I Chundrigar Road, Karachi, Pakistan Tel : +(92 21) 32469141 50 research@shajarcapital.com

ThePrism
Power
CoalconversionApotentialrespiteforenergywoes

KSE100Index Change PowerSector MarketCap(PkRbn) MarketCap(US$bn) 2,640 25.01 27104.70 103.75

Higher Generation cost of electricity has made the government to think regarding cheaper viable sources of electricity generation and thus, coal conversion has recently gained advocacy in the policy circles. On Jun 2813 while clearing the circular debt, the Government of Pakistan signed a Memorandum of Understanding (MoU) with four IPPs namely Hub Power, Pakgen Power, Lalpir Power and Saba Power to convert their plants from Furnace oil (FO) to coal. Conversion to coal bodes well for the economy by reducing its sensitivity to global price shock and creating much needed fiscal space for the government. Besides, the involved IPPs will also benefit in the shape of higher ROE, curtailment of efficiency losses and extension in period ofPPA. However,theroadaheadmaynotbeassmoothasinitiallyperceived,giveni) absence of policy guideline, ii) financing of the project and iii) availability of coal.

GenerationCapacitiesofIPP's(MW)
1400 1200 1000 800 600 400 200 0 HUBC
Source:CompanyReports,ShajarResearch

PositiveImplicationfortheeconomy
The conversion of IPPs (SABA nonoperational) can potentially convert approximately 30% of the FO consumption to 44.5mn tons of imported coal. Our calculation suggests that this substitution would yield an annualized foreign exchange saving of around US$11.5bn at current market prices. It will also potentially reduce the weighted average cost of power generation by PkR1.01.2/kWh, resulting into an annualized saving of PkR8090bn (0.4% of GDP).

PKGP

LPL

SABA

Hurdlesonthewayahead
Though there has been vocal urgency shown by the government to fast track the coal conversion process, on ground developments are in stalemate. The four IPPs are still awaiting the approval of the policy guidelines for their conversion. During the tariff determination process, we believe a possible source of contention may emerge with regard to the assigned ROE of the projects. A lower level of assigned ROE of the project may force the individual companiestoshelftheprojectfortimebeingatleast.

IPPs HubPowerCompany PakgenPowerLimited LalpirPowerLimited

Source:ShajarResearch

BaseCaseEPSImpact (PkR) 3.2 4.0 4.4

Furthermore, the conversion of IPPs would require a hefty capital requirement of US$2bn of which 7080% is to be funded by debt. Such a magnanimous amount seems difficult to be funded through domestic sources, while environmental issues increases the risk associated with international financing oftheseprojects.

BenefitsforIPPs
Given a go ahead of conversion process at threshold ROE levels, we believe it bodes well for the companies involved. At basecase of 17% ROE and debt to equitystructureof80:20,theprojectswouldaddPkR4/sharetoHUBCTPwhile PkR6 would be added to Pakgen and Lalpir valuations. Besides, higher ROE component, reduced levels of efficiency loss will also bode well for the individualcompaniesoutlook.

MuhammadAwaisAshraf
Tel:+(9221)3246914150Ext542 awais.ashraf@shajarcapital.com

Shajar Capital Pakistan (Private) Limited. (Formerly Burj Capital Pakistan (Private) Limited.) Disclaimer: All reports and recommendations have been prepared for your information only. Summary and Analysis are not recommendation to Buy or Sell. This information should only be used by
investors who are aware of the risk inherent in securities trading. The facts, information, data, indicators and charts presented have been obtained from sources believed to be reliable, but their accuracy and completeness cannot be guaranteed. Shajar Capital Pakistan (Private) Limited (Formerly Burj Capital Pakistan (Private) Limited) and its employees are not responsible for any loss arising from use of these reports and recommendations.

Energyissuescausingproblems

Inthelastfiveyears (FY0913),Pakistans GDPhasgrownby anaverageof3%, wellbelowits averagehistorical growthrateof5%.

With the government searching for viable solutions to overcome the rampant energy crisis, the conversion of Pakistans energy mix towards coal hasgained advocacy in policy circles. The countrys energy mix has heavily tilted towards expensive Furnace Oil (FO) creating multiple issues on the economic front. Where it has increased the countrys sensitivity to international oil prices (i.e. oil bill accounts for 35% of import receipts), expensive fuel choice has also manifested into higher subsidy outlay (emergence of notorious circular debt) and underutilization of generation resources. Subsequently, higher power outages have caused the countrys economy to underperform. In the last five years (FY0913), Pakistans GDP has grown by an average of 3%, well below its average historical growth rate of 5%. In recent times, the country has also underperformed its regional peers including India, Bangladesh and Sri lanka which have registered an average growth of above 6% in thelastfiveyears.

Pakistan'sEnergyMix
120% 100% 80% 60% 40% 20% 0% Oil Gas Hydel Others

FY07

FY12

Source:NEPRA,KESC,MoP,ShajarResearch

FY13E

Needforcoalconversion As a feasible solution to curb the energy crisis, there has been increased focus on reducing the cost of power generation by introducing cheaper resources into the energy mix. In this regard, power generation from coal provides a unique opportunity that currently accounts for only 0.1% of our energy mix. This is in stark contrast to the examples of our neighbors, namely India and China where approximately60%ofelectricityisgeneratedthroughcoal.

ElectricityGenerationMix

China
4% 8% 22% 10% 16% 65%

India
Coal 14% Hydropower 57%

Oil&Gas

Others

Source:IndiaCentralElectricalAuthority&FactsGlobalEnergy

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Conversiontocoal:intentshown
The Government of Pakistan while clearing the stock of circular debt in Jun13 signed a Memorandum of Understanding (MoU) with four IPPs (Independent Power Producers) namely Hub Power Company (HUBC), Pakgen Power (PKGP), Lalpir Power (LPL) and Saba Energy (SABA) for conversion of their plants to coal. The companies have a cumulative generation capacity of 2,150MW that represent 9.5% of the current installed capacity. Besides, the government has also planned to convert three of its thermal stations (Jamshoro unit 1&3, Muzaffargarh unit 16 and Guddu unit 14) with a capacity of 2,840MW to coal. However, due to extensive overhauling requirement of Gencos, we have learnt that the government is instead considering new greenfield projects.

Thegovernmenthas announcedanROEof 17%onimportedcoal and20%onlocalcoal intheupfronttarifffor newprojects.

The government in Sep13 has also announced an upfront tariff for the new coal projects granting ROE (Return on Equity) component of 17% on imported coal while 20% ROE has been assigned for theuseoflocalcoal.

Though coal conversion is at an infant stage, positive developments hold favorable implications for theeconomicfactorsaswellasthecompaniesinvolved.

Positiveimplicationsfortheeconomy

Apotentialsaviorofexternalaccount The swing of the energy mix towards relatively cheaper coal may reduce the countrys external account sensitivity to global commodity price shocks. The memories of 2008 oil price saga and its ill effectsontheeconomyarestillfreshinourminds.Torecall,theriseofinternationalcrude oilprices toanalltimehighofUS$146/bbl(Jul08)widenedthecurrentaccount(CA)deficittoUS$14bn(8%of GDP) in FY08 from US$7bn (4% of GDP) the year before. The countrys forex reserves fell by 42% in five months (JulNov08) to US$6.5bn, with reserves of the central bank standing at US$3.4bn (one month import cover). This further forced the PkR to depreciate by a steep 12% in this period. Inflationrosetoaveragearound24%(oldbase)in1HFY09.Subsequently,thecountryreenteredthe folds of the IMF in Nov08 to avert the Balance of Payment (BoP) crisis. The residual effects of the 2008 event are still experienced by Pakistans economy in the form of circular debt that emerged at thattime.
Int'lcrudeoilpricesandimportbillsensitivity
US$(bn) 12 10 8 6 4 2 0 ImportBill(LHS) Crudeoilprices(RHS) US$/bbl 140 120 100 80 60 40 20

Int'lcrudeoilpricesandcurrentaccountsenstivity
US$(bn) 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 CAdeficit(LHS) Crudeoilprices(RHS) US$/bbl 140 120 100 80 60 40 20

1QFY

2QFY

3QFY

4QFY

1QFY

2QFY

3QFY

4QFY

1QFY

2QFY

3QFY

4QFY

1QFY

2QFY

3QFY

1QFY06

2QFY06

3QFY06

4QFY06

1QFY07

2QFY07

3QFY07

4QFY07

1QFY08

2QFY08

3QFY08

4QFY08

1QFY09

2QFY09

3QFY09

Source:SBP,Bloomberg,ShajarResearch

4QFY09

Source:SBP,Bloomberg,ShajarResearch

Impactofint'lcrudeoilpricesondomesticinflation
30% 25% 20% 15% 10% 5% 0% CPI(LHS) Crudeoilprices(RHS) US$/bbl 140 120 100 80 60 40 20

ComparisonofForexReserveswithPKR/US$
US$(bn) 16 14 12 10 8 6 4 2 0 ForexReserves(SBP) PkR/US$ PKR/US$ 85 80 75 70 65 60 55 50 45 40

May08

May09

Sep07

Sep08

Mar'08

May'08

Mar'09

Nov'07

Nov'08

May'09

Nov08

Jan09

Mar08

Mar09

Nov07

Jan08

Jul08

Sep'07

Jan'08

Jul07

Sep'08

Jan'09

Jul'07

Jul'08

4QFY

Source:PBS,Bloomberg,ShajarResearch

Source:SBP,ShajarResearch

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Ourcalculation suggestthatapprox. 2530%ofoilbillis attributedtoFO whichaccountsfor 10%oftotalimport receipts.

Fast forward to present time, the oil bill currently accounts for 35% of the total import bill. Drilling deep, calculations suggest 2530% of that oil bill is attributed to FO, which accounts for approximately 10% of the total import receipts. In volumetric terms, FO demand stands at around 8.5mn tons per annum, which is 43% of the total (19.5mn tons) oil consumption of the country. Furthermore, of the total FO demand approximately 30% of the demand is met through domestic productionwhiletheremainingismetthroughimports.Itshouldbehighlightedthatthedemandfor FO could have beeneven higher, if circular debt has not restricted the domestic generation capacity. Therefore, the coal conversion process would help the country to substitute the expensive import withrelativelycheaperalternate(i.ecoal).
HistoricalImportrecepitswithoilbill US$(bn)
45 40 35 30 25 20 15 10 5 25% 30% 35% OilBill(LHS) Others(LHS) Oilbillcontribution(RHS) 40%

FObillcontributiontooilandtotalimportbill
35% 30% 25% 20% 15% 10% 5% 0% Tooilbill Tototalimport

FY08

FY09

FY10

FY11

FY12

FY08

FY09

FY10

FY11

FY12

Source:SBP,ShajarResearch

FY13

Source:OCAC,SBP,ShajarResearch

Pakistan'shistoricaloilsalesandFOcontribution
mnton 25 20 15 10 5 35% 45% FO TotalOilsales FOcontribution 50%

Pakistan'shistoricaloilsalesandFOcontribution
mnton 8 7 6 5 4 40% 3 2 1 55% 50% 70% 65% 60% LocalProduction Imports Importcontribution 80% 75%

FY08

FY09

FY10

FY11

FY12

FY13

FY08

FY09

FY10

FY11

FY12

FY13

FY13

Coalconversionof IPPswouldyieldan annualizedforeign exchangesavingof aroundUS$11.5bn.

Source:OCAC,ShajarResearch

Source:OCAC,ShajarResearch

Assuming similar load factors, the conversion of the three operational IPPs (SABA nonoperational) can potentially convert approximately 30% of the FO consumption to 44.5mn tons of imported coal. Our calculation suggests that this substitution would yield an annualized foreign exchange savingofaroundUS$11.5bnatcurrentmarketprices.

Asteptoaddressthesubsidyissue Coalconversioncanalsohelpthegovernmenttobringitsfiscalhouseinorder.Theunfavorablefuel mixhasresultedinescalationofcostofpowergenerationwhichhasnotbeencompletelypassedon to the final consumer. The resultant tariff differential has caused a substantial increase in the amountreleasedinlieuofsubsidiesandispartiallytobeblamedfortheemergenceofcirculardebt. The power sector on an average has consumed 84% (or PkR1.5tr) of the total subsidies share since FY09andaccountsfor24%ofthecumulativedeficitofthelastfiveyears.

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Trendofsubsidiesgiventopowersector PkRbn 600 500 400 300 200 100 CurrentSubsidies(LHS) ShareofPowerSector(%) 100% 90% 80% 70% 60% 50% 40% 30% 20%

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

Though the government has recently taken a bold step to increase the average notified tariff by approximately30%toestimatedPkR.14.5/kWh,tariffdifferentialstillstandsaroundPkR3/kWh.This culminates into a subsidy outlay of approximately PkR200240bn against the budgeted target of PkR220bn.

Source:FederalBudgetDocument,ShajarResearch

Conversioncan resultintoan annualizedsavingof PkR8090bn(0.4%of GDP).

At current market prices, it is estimated that the cost of coal based power generation is 30% lower ascomparedtogasbasedgenerationandasizable80%lowerascomparedtoFObasedgeneration, which can substantially reduce the cost of power generation. To elaborate it further, FO has an average generation cost of PkR17/kWh for the four IPPs compared to PkR4/kWh for imported coal. Conversion of IPPs from FO to imported coal can potentially reduce the weighted average cost of power generation by PkR1.01.2/kWh, resulting into an annualized saving of PkR8090bn (0.4% of GDP).

FY14B

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Hurdlesonthewayahead

Despite the clear advantages of coal conversion, we believe the road ahead may not be as smooth as initially perceived. The major obstacles to overcome include i) determination of reference tariff for the projects and ii) arrangement of financing for these projects with significant capex requirements. Moreover, the other two hurdles of relatively less significance include availability of coalanddisposalofashcontent.

Thegovernment authoritiesare offeringanROEof 1718%againstthe demandof20%by IPPs.

Policyguidelinesstillawaiting Though there has been vocal urgency shown by the government to fast track the coal conversion process, on ground developments are in stalemate. Though National Electric Power Regulatory Authority (NEPRA) has provided an upfront tariff for new coal based projects, the four IPPs are still awaiting approval of policy guidelines for their conversion. The Economic Coordination Committee (ECC) in its meeting on Dec 1714 directed NEPRA to determine the tariff for IPPs within a period of 45 days. However, given the past precedence, the development may be prone to time delay which wouldpotentiallyforcetheIPPstoshelftheircoalconversionprojectsforthetimebeingatleast.

During the tariff determination process, we believe a possible source of contention may emerge with regard to the assigned ROE of the projects. Our channel checks suggest that the government authorities are offering an ROE of 1718% (as given for upfront tariff) on these projects against the demand of 20% by individual companies. Furthermore, the matter of life extension of the projects andallowablecapex(otheroverhaulingrequirementsoftheplantforitslifeextension)alsoneedto be sorted out in these tariff determination negotiations. Given the extensive overhauling requirements, proponents of the new projects may gain advocacy which could possibly shelf the mentioned coal conversion process. Appropriate approval would enable the companies to pursue theirproposalswithfinancialinstitutions.

Environmental issues(asit increasescountrys carbonfootprint) increasetherisk associatedwith international financing.

Financinganothermajorhurdletoovercome The conversion of IPPs would require a cumulative amount of approximately US$2bn of which 70 80% is to be funded through debt. Such a magnanimous amount seems difficult to be funded through domestic sources as this represent approximately 4% of total outstanding bank advances. On the other hand, environmental issues (as it increases countrys carbon footprint) increase the risk associated with international financing of these projects. A viable solution in this regard would be of lease financing by the vendors of the respective machinery. However, earlier mentioned modalitiesofthefinancingarecontingentonapprovalofthepolicyguidelinesbythegovernment.

On the equity front, we believe the companies may raise the required amount by holding back the dividend during the conversion phase. In this regard, a possibility of right issue by some companies cantberuledout.

Though,current measuredreserves (exofThar)hasa potentialreservelife of60years,but enhancingthelocal productionwouldbe ahurdleatleastin theshortrun.

Coalavailability The coal conversion of the four IPPs will give rise to incremental demand of around 4.55mn tons per annum, which currently stands at 7.7mn tons per annum. In this regard, total measured reserves of indigenous coal stands at 750mn tons (ex Thar measured reserves of 2700mn tons) and Pakistan is currently producing around 3.5mn tons of coal per year. Though current reserves (ex of Tharmeasuredreserves)haveapotentialreservelifeof60years,mininghurdlesmaynotallowthe country to immediately lift its production for the incremental demand. Therefore, we believe the imported coal will have to form the primary source of generation against the governments intentionofemployingtheindigenoussources.

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 MeasuredCoalReserves HeatingValueRange(mmmf) (Btu/lbu) mntons Badin 150 11,415 11,521 Jherruck 106 8,800 12,846 Lakhra 244 5,503 9,158 IndusHeat 51 7,782 8,660 SaltRange 50 9,472 15,801 SondaThatta 60 8,878 13,555 Other 89 5,219 14,357 SubTotal(exTharCoal) 750 TharCoal 2,700 6,244 11,040 Total 3,450 Source:EnergyYearBook2012. In order to facilitate the conversion process, the National Transmission and Despatch Company Limited (NTDC) has proposed that jetty construction for Pakistan Power Park can also be used for importofcoalbytheseIPPs.However,muchisyettobeunveiledonthisfront. Annually,3.3mn tonsofashwillbe producedbythese IPPsaftercoal conversion.

Ashdisposal With a conversion of these plants to coal, approximately 3.3mn tons of coal ash (contains fly and bottom)willbeproduced.Disposalofbothflyandbottomashwillbeamajorissue.Flyashcontains contaminants such as silicon dioxide, calcium oxide etc. can be controlled by using electrostatic precipitatorsorotherfilteringequipments.Coalashcanbeusedinconstructionofroadsandaswell asasubstituteforPortlandcement(forconstruction)andclay(usedincementclinkerproduction).

Page 7 of 10

BenefitforIPPs
HubPowerCompany(HUBC) Conversion of HUBCs base plant to coal will bode well for the company in the form of higher ROE on incremental equity, a potential improvement in fuel efficiency and extension in Power Purchase agreement. However, we believe the project feasibility is contingent on the assigned ROE for the project (see section on issues). HUBC requires an estimated amount of US$800mnUS$1bn to convert its four oil fired boilers to coal. Assuming debt to equity structure of 80:20 and project ROE at17%asourbasecase,weestimateannualizeearningimpactofPkR3.2/shareandincreaseourTP by PkR5/share. In case the projected ROE is increased to 20%, the earning impact increases to PkR3.8/sharewithTPimpactofPkR8/share.
ImpactonEarning/TargetPricepershare ProjectedROE 17% 20% 20% 3.2/4.5 3.8/8.4 EquityPortion 30% 4.8/6.8 5.7/12.6

Further upside to our projection may come from improved efficiency of the plant. Our calculations suggest that the base plant is currently incurring inefficiency losses of around 0.5% that translate into reduced EPS of PkR1.8/share. Thus, conversion process can further augment the companys valuationbyreducingthecomponentofefficiencylossforthecompanysearnings. PakgenPowerLimited(PKGP) The estimated cost of the project is US$400mn, with equity share of 2030%, for the conversion of companys 365MW plant. The conversion can save approximately 6g/kWh loss of fuel for the company. As per our base case, the earning will augment by PkR4.0/share and TP by PkR6/share. ROE component of 20% have an annualized impact of PkR4.7/share and PkR10/share on earnings andtargetpriceofcompany,respectively.
ImpactonEarning/TargetPricepershare ProjectedROE 17% 20% 20% 4.0/5.6 4.7/10.5 EquityPortion 30% 6.0/8.4 7.1/15.7

Source:ShajarResearch

Moreover, as the plant consists of only one boiler, a new boiler will be constructed parallel to the existing boiler while the plant remains in operation. The new boiler will then be connected with the existing steam turbine generator in a period of six months. During this period, the plant will be shutdownandthecompanywillkeeponreceivingcapacitypayments.

Source:ShajarResearch

LalpirPowerLimited(LPL) LalpirPowerPlantisidenticaltoPakgenPowerhavinggrosscapacityof362MWwithasingleboiler. In basecase scenario, the annualized earnings will enhance by PkR4.4/share and TP by PkR6/share. Assuming ROE of 20%, the annualized earnings impact will be increased to PkR5.2/share, with TP impact of PkR11/share. The coal conversion also holds the potential to eliminate the efficiency loss whichiscurrentlyestimatedtostandaround1.7%fromapprovedlevels.Thereductionofefficiency loss may add PkR4.2/share to the companys earnings. However, it will take a period of around threeyearstomaterializethisimpact.
ImpactonEarning/TargetPricepershare ProjectedROE 17% 20% 20% 4.4/6.2 5.2/11.5 EquityPortion 30% 6.6/9.3 7.8/17.3
Source:ShajarResearch

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ACRONYMS
BoP CA BalanceofPayment CurrentAccount EconomicCoordinationCommittee FurnaceOil GrossDomesticProduct GeneratingCompanies HubPowerCompany InternationalMonetaryFund IndependentPowerProducer KarachiElectricSupplyCompany LalpirPowerLimited Moistmineralmattaerfree MinistryofPetroleum MemorandumofUnderstanding NationalElectricPowerRegulatoryAuthority NationalTransmissionandDespatchCompany OilCompaniesAdvisoryCommittee PakistanBureauofStatistics PakgenPowerLimited PowerPurchaseAgreement ReturnonEquity SabaPowerLimited StateBankofPakistan

ECC FO

GDP Genco HUBC IMF IPP KESC LPL mmmf MoP MoU NEPRA NTDC OCAC PBS PKGP PPA ROE SABA SBP

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1st Floor, P&O Plaza, I.I Chundrigar Road, Karachi, Pakistan Tel : +(92 21) 32469141 - 50 -Ext 541 Email: research@shajarcapital.com

RatingDefinitions
Buy Accumulate Hold Reduce Sell 20%potential >5%to<20%potential 5%to5%potential 5%to>20%potential >20%potential

Disclaimer: All reports and recommendations have been prepared for your information only.
Summary and Analysis are not recommendation to Buy or Sell. This information should only be used by investors who are aware of the risk inherent in securities trading. The facts, information, data, indicators and charts presented have been obtained from sources believed to be reliable, but their accuracy and completeness cannot be guaranteed. Shajar Capital Pakistan Private Limited (Formerly BurjCapitalPakistan(Private)Limited)anditsemployeesarenotresponsibleforanylossarisingfrom useofthesereportsandrecommendations.

Analyst Certification: The research analyst(s), Muhammad Awais Ashraf, for this report certifies
that: (a) all of the views expressed in this report accurately reflect his personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analysts compensation was,is,orwillbedirectlyorindirectlyrelatedtothespecificrecommendationsorviewsexpressedby theresearchanalyst(s)inthisreport.

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