Introduction

Section 62 of the Electricity Act, 2003 empowers regulators to determine tariffs under a regulated framework, primarily to safeguard the financial viability of power producers, especially large public sector undertakings (PSUs) such as NTPC and NHPC. The terms and conditions for tariff determination as laid by CERC also applied  on the SERCs as per Section 61(a) of the Electricity Act,  This mechanism, played a crucial role in attracting investments and expanding generation capacity during times of acute power shortages. However, with private investment having since made India’s installed capacity broadly adequate, the continued reliance on this framework increasingly tilts the balance in favour of generators, often at the expense of consumers and distribution companies (DISCOMs).

One of the most debated elements is the Return on Equity (RoE) allowed under the Central Electricity Regulatory Commission (CERC) framework: 15.5% after tax. This is not only one of the highest regulated returns on equity globally (even higher than the 13% allowed in Pakistan’s highly stressed power sector), but its method of calculation further compounds the burden on consumers.

Why CERC Allows 15.5% Post Tax RoE

The CERC justifies such a high post-tax return on equity for several reasons:

1.     To provide strong investment signals for new capacity addition in a capital-intensive sector.

2.     To compensate generators for sectoral risks such as fuel supply uncertainty, payment delays, and policy changes.

3.     To maintain the financial health of PSUs, which are the backbone of India’s generation capacity.

4.     To align with historical practice where high RoEs were used to attract capital during years of electricity shortages.

5.     To compensate for the absence of returns during the construction period of power plants, which can extend up to four years.

While these arguments may have been valid in the past, the electricity sector today is far more mature. India is now power-surplus, renewable energy is increasingly competitive, and DISCOM finances remain fragile. A potential conflict of interest may partly explain the continuation of relatively high Return on Equity (RoE) under the cost-plus regulatory framework. First, members of the Central Electricity Regulatory Commission (CERC) are normally selected from CPSUs, which also happen to be the primary beneficiaries of such high RoE norms. This background, while bringing valuable experience, may at times influence perspectives on what constitutes fair returns out of institutional loyalty. Second, the Government, as the majority owner of these CPSUs, benefits from higher profits through dividend payouts overshadowing it welfare role. This dual role of the Government—as regulator (through appointments of members of CERC) and shareholder—can create an inherent tension, making it more challenging to fully align regulatory outcomes with consumer interest, since higher RoE tends to raise tariffs and add to the burden on end-users.

Now let us see how the risks of CPSU are mitigated-

Key Risks and Mitigation in Regulated Tariff Thermal Plants

Thermal plants operating under regulated tariffs face several key risks, but the regulatory framework provides mechanisms for mitigation. One major risk is fuel price volatility, as fluctuations in domestic coal prices, imported coal or LNG costs, and transportation charges can significantly affect input costs. To address this, a fuel cost adjustment (FCA) or fuel surcharge mechanism is allowed as a pass-through in the Energy Charge Rate (ECR). In addition, long-term linkages with Coal India or similar supply contracts help reduce exposure to volatile spot prices.

A second risk stems from foreign exchange exposure, particularly in the case of imported coal, LNG, or equipment where payments are denominated in foreign currency. This risk is mitigated through hedging, with the cost of such hedging permitted as a pass-through in tariffs. Moreover, regulators allow recovery of forex variations under the Change-in-Law provisions or through tariff adjustments.

Inflation and interest rate movements also pose challenges, as rising inflation or interest costs increase the burden of capital servicing. This is mitigated by fixing debt servicing costs at the time of tariff approval, while refinancing gains or losses are shared between utilities and consumers in accordance with regulatory norms. To ensure investor confidence, Return on Equity (RoE) is provided on a post-tax basis and remains indexed.

Another significant concern is demand and off-take risk. Lower demand growth or rising renewable energy penetration can reduce thermal dispatch. However, the two-part tariff system ensures that capacity charges are recovered as long as availability is declared, regardless of the level of scheduling. The availability-based tariff (ABT) framework further strengthens this, as recovery is linked to declared availability rather than actual generation.

Finally, payment delays from distribution companies (DISCOMs) continue to be a persistent risk, given their weak financial health and high receivables. To mitigate this, the Late Payment Surcharge (LPS) mechanism provides compensation for delayed payments, while payment security measures such as letters of credit (LCs) and escrow accounts have been made mandatory to protect generating companies.

CPSU Protection Under Tripartite Mechanism

A frequently cited justification for the high 15.5% post-tax RoE is that generating companies face the risk of delayed or non-payment by state distribution companies. However, for central public sector undertakings (CPSUs) like NTPC, NHPC and PGCIL, this risk is practically eliminated. Under the tripartite agreement between the Government of India, state governments, and the Reserve Bank of India (RBI), any default by a DISCOM automatically triggers recovery of unpaid dues directly from the concerned state’s fund, with the amount credited to the CPSU. This extraordinary protection ensures that CPSUs face virtually no counter-party risk, turning the rationale of “compensating risk” on its head. In effect, the guaranteed RoE for CPSUs functions as an assured profit mechanism, divorced from commercial uncertainty—further weakening the case for maintaining such high regulated returns.

The Contrast with Independent Power Producers (IPPs)
In contrast, Independent Power Producers (IPPs) do not enjoy sovereign-backed protection and remain fully exposed to the payment risks of financially distressed DISCOMs. Their revenues are vulnerable to mounting receivables, delayed remittances, and higher financing costs arising from payment risk. For instance, Tata Power’s Return on Equity (RoE) over the past five years has been averaging only around 10–11%—well below the assured 15.5% post-tax RoE guaranteed to CPSUs. The asymmetry is stark: while IPPs must contend with market volatility, fuel price fluctuations, and counter-party risks, CPSUs are guaranteed one of the highest regulated returns globally, further cushioned by the tripartite agreement with the RBI that virtually eliminates the possibility of payment default. The outcome is a regulatory framework that secures assured profitability for PSUs while leaving private investors to bear real commercial risk, undermining competition and distorting the level playing field.

Issue of return during construction period

The justification that higher RoE is required to offset construction-period equity risk appears less persuasive when viewed against global practice. In jurisdictions such as the US and parts of Europe, regulators address this challenge either by allowing limited recovery through CWIP or AFUDC (Allowance for Funds Used During Construction) during the build phase, or by permitting cost-of-capital adjustments for long-gestation projects—while keeping operational RoE at modest levels. India’s approach, by contrast, relies on a permanently elevated RoE that extends well beyond the temporary risk of construction, thereby creating an undue and long-term burden on consumers. Mechanisms like AFUDC ensure that equity is not left uncompensated during construction, which is why US regulators are able to maintain operational RoE in the range of 9–10%, compared to 15.5% in India.

The Depreciation Paradox

In standard corporate finance, both debt and equity investments are recovered over the life of an asset. Depreciation, a non-cash expenditure, ensures that the asset cost (including the equity contribution) is returned to investors progressively. However, under current tariff regulations, equity is not depreciated for the purpose of RoE calculation. This means that even though consumers repay the capital cost through depreciation charges, the equity base is assumed to be intact for the entire 25-year life of the plant.

The result is significant over-compensation of generators as can be seen from following

1. Input Assumptions (CERC 2024 compliant)

• Installed Capacity = 800 MW

• Capital Cost = ₹8 crore/MW → ₹6,400 crore

• Debt: Equity = 70:30 (Reg. 18) →

  • Equity Base (E₀) = 30% × 6,400 = ₹1,920 crore

• Return on Equity (RoE) base rate = 15.5% (for new thermal, Reg. 30(3))

  • Actual tariff allows pre-tax RoE = 15.5% ÷ (1 – effective tax rate) (Reg. 31). For clarity, I’ll compute using 15.5% post-tax (gross-up can be added later).

• Depreciation (Appendix II, Reg. 33):

  • Straight-line, 4.22% of original cost for first 15 years.

  • Remaining depreciable value (90% – cumulative depreciation in first 15 years) spread over balance useful life (10 years).

  • Salvage = 10% → total depreciation = 90% × 6,400 = ₹5,760 crore.

2. Depreciation Schedule (per Regulation 33, Appendix II)

• Years 1–15: Depreciation SLM = 4.22% × 6,400 = ₹270.08 crore/year

  • Cumulative = 270.08 × 15 = ₹4,051.2 crore

• Balance depreciable value = 5,760 – 4,051.2 = ₹1,708.8 crore

• Years 16–25: Depreciation = 1,708.8 ÷ 10 = ₹170.88 crore/year

• Equity reduction each year (if equity depreciated) = 30% × Depreciation

3. Case (A) – Equity not depreciated (CERC normative treatment)

• Equity base constant = ₹1,920 crore

• RoE = 15.5% × 1,920 = ₹297.6 crore every year (Years 1–25)

• Total RoE over 25 years = ₹7,440 crores

(If pre-tax RoE is required, gross-up: e.g., if MAT = 25%, pre-tax = 15.5 ÷ (1–0.25) = 20.67% → annual RoE = 396.8 crore.)

4. Case (B) – Equity proportionally depreciated (hypothetical what-if)

Here, equity reduces by 30% of each year’s depreciation.

Years 1–15 (Depreciation = ₹270.08 crore; Equity reduction = ₹81.02 crore/yr)

• Yr 1 Equity = 1,920 → RoE = 297.6

• Yr 2 Equity = 1,838.98 → RoE = 285.04

• … continues falling by 81.02 each year …

• Yr 15 Equity = 785.72 → RoE = 121.79

Years 16–25 (Depreciation = ₹170.88 crore; Equity reduction = ₹59.37 crore/yr)

• Yr 16 Equity = 726.36 → RoE = 112.58

• Yr 17 Equity = 666.98 → RoE = 103.38

• … continues falling by 51.26 each year …

• Yr 25 Equity = 192.00 → RoE = 29.76

✔ Final equity at end of 25 years = ₹192 cr, which equals 30% of salvage value (₹640 cr).

5. Results Comparison (CERC 2024 framework)

·       Case A – Without equity depreciation: RoE remains fixed at ₹ 297.6 crore every year for 1-25 years totalling ₹7,440 crore.

·       Case B – With equity depreciated proportionally: RoE falls gradually from ₹ 297.6 crore in year 1 to ₹111.64 crore after 15 years and then from ₹ 99.08 Crore in 16th year to ₹29.76 Crore in 25th year totaling ₹ 3857 Crore (Annexure-1)

·       Consumers thus pay an extra ₹ 3583 Crore or around 92.8 % extra due to the non-depreciation of equity.

How United States and European Regulators Treat Equity

Now let us compare it to practices followed in other major regions

🔹 United States (FERC & State PUCs)

1. Equity Base

• Equity is not depreciated.

• Like India’s CERC, the rate base (on which utilities earn a return) is defined as Net Plant in Service (original cost – accumulated depreciation) + Working Capital + Regulatory Assets – Customer Contributions.

• The equity portion of the rate base is calculated via the allowed capital structure (e.g., 50% debt / 50% equity).

• Hence, depreciation reduces the overall rate base, but equity is not separately reduced year by year.

2. Allowed Return

• FERC and State regulators determine an allowed RoE (%) using the Capital Asset Pricing Model (CAPM), Discounted Cash Flow (DCF), or Risk Premium methods.

• Typical allowed RoE in 2020s: 9%–10.5% post-tax (varies by utility and region).

• This is lower than India’s 15.5% because capital markets in the US are deeper and cost of equity is considered lower.

3. Depreciation

• Depreciation is passed through separately in tariff, to return invested capital over the asset’s useful life.

• Thus, utility earnings = Operating Costs + Depreciation + (Rate of Return × Rate Base).

✅ Key Point: US regulators never depreciate equity separately; they reduce the rate base by depreciation of total plant (debt + equity together). RoE is earned on whatever equity % applies to the shrinking rate base.

🔹 Europe (Ofgem – UK, BNetzA – Germany, CRE – France, etc.)

1. Equity Base

• Europe typically uses a Regulatory Asset Base (RAB) model.

• RAB = Historical cost or indexed cost of assets – Depreciation.

• Allowed return = WACC × RAB, where WACC is based on assumed gearing (debt: equity) and cost of equity/debt.

2. Allowed Return

• Cost of equity is estimated from CAPM (risk-free rate + beta × equity risk premium).

• Ofgem (UK, RIIO-2, 2021–2026): Allowed post-tax cost of equity = ~4.55%, with gearing assumed at ~60% debt / 40% equity.

• BNetzA (Germany): Allowed RoE ~ 5–7% (post-tax) depending on regulatory period.

• CRE (France): Similar ~ 4–6%.

• These are much lower than India’s 15.5%, reflecting lower risk-free rates in Europe.

3. Treatment of Depreciation

• Depreciation reduces RAB each year, but RoE is still applied on the equity share of RAB (i.e., equity shrinks in line with RAB, but not separately depreciated).

• This is subtly different from CERC, which keeps equity base fixed (not reduced as plant depreciates).

✅ Key Point: European regulators use WACC × (shrinking RAB), so equity earns a return on a shrinking base. Effectively, it is closer to your “equity depreciated proportionally” scenario.

Comparative Summary 

Under the CERC 2024 framework in India, equity is fixed at 30% of the admitted capital cost and is not reduced by depreciation. The allowed RoE is 15.5% post-tax (grossed up to pre-tax for billing), while depreciation is provided separately on a straight-line basis with 10% salvage value. The net effect is that equity continues to earn the full RoE for the entire 25-year period, even though the underlying asset is depreciating.

In the United States (FERC and State PUCs), equity forms part of the rate base, and while depreciation does not reduce equity separately, it reduces the overall rate base over time. The typical RoE allowed is in the range of 9–10.5% post-tax, with depreciation accounted for separately. This means that RoE is effectively applied on a shrinking base as assets depreciate.

In Europe (UK, Germany, France), equity is implicit in the Regulatory Asset Base (RAB), and depreciation directly reduces the RAB. Allowed RoE is much lower, typically 4–7% post-tax, and since the RAB shrinks with depreciation, the equity portion also declines over time. This structure is closer to the “equity depreciated proportionally” model, unlike India’s approach where equity remains intact throughout the asset life.

✅ Bottom line:

• India (CERC 2024) is more favorable to generators, since equity is not reduced and RoE is higher (15.5%).

• US model keeps equity fixed in capital structure but shrinks the rate base.

• European model explicitly shrinks the equity base with RAB depreciation, so returns decline over time (like proportional equity depreciation case).

European regulatory frameworks adopt a more balanced approach. Regulators in countries such as Germany, the UK, and France explicitly allow equity to be depreciated along with the asset. This means the equity base reduces each year in proportion to depreciation, and RoE is calculated only on the net equity remaining at risk.

Additionally, RoE rates allowed in Europe are much lower, typically between 6% and 8% post-tax. This aligns investor compensation more closely with actual risks and ensures consumer tariffs remain affordable.

The Double Whammy for Consumers and DISCOMs

The combination of a high RoE (15.5% post-tax) and the non-depreciation of equity creates a double whammy for India consumers and distribution companies:

1. Consumers are locked into paying inflated fixed charges for 25 years.

2. DISCOMs face higher power purchase costs, reducing their ability to manage financial losses.

3. Affordability of electricity is compromised, hitting households and small industries the hardest.

4. Industrial competitiveness suffers as tariffs remain elevated compared to global benchmarks.

Impact on Affordability and Power Market optimization

For state DISCOMs, already burdened with high aggregate technical and commercial (AT&C) losses and subsidy obligations, these elevated capacity charges restrict flexibility. DISCOMs cannot take full advantage of cheaper renewable or market-based electricity and are forced to keep passing high fixed costs onto end consumers.

Besides, although high Annual Fixed Charges (AFC) due to regulated tariff are not part of the merit order in SCED or MBED, they indirectly constrain both mechanisms. Under regulated PPAs, DISCOMs are obligated to pay AFC in full as long as generators meet availability norms, irrespective of actual dispatch. This creates a sunk-cost bias: DISCOMs often prefer scheduling high-AFC contracted plants instead of relying on cheaper market-based options, since backing down does not reduce their fixed cost burden. In SCED, this limits the scope of economic optimization, while in MBED it poses a bigger challenge—if a DISCOM’s contracted high-AFC plant is not dispatched, the DISCOM must still pay its fixed charges while also buying energy from the market, effectively leading to double payment. Thus, while AFC is not directly used in dispatch algorithms, high fixed costs distort incentives, reduce the efficiency of market-based dispatch, and highlight the need for a financial settlement framework to reconcile PPA obligations with pooled dispatch.

The Way Forward

Reform is necessary if India wants to balance consumer welfare with generator viability:

·       Align RoE with global benchmarks of 8–10%.

·       Allow equity depreciation proportionally with asset depreciation.

·       Transition to competitive procurement and market-linked tariffs to reduce reliance on regulated returns.

Conclusion

CERC’s RoE framework was instrumental in attracting capital and ensuring the viability of power projects during periods of deficit, enabling rapid capacity addition when risk perception was high and capital scarce. However, in today’s renewable-rich environment and market-based approach, the same framework has turned into a source of overcompensation. By maintaining one of the highest regulated RoE in the world—15.5% post-tax—and by not reducing equity in line with depreciation, the tariff design effectively subsidizes public sector generators while undermining affordability for DISCOMs and consumers. In contrast, regulators in the US and Europe allow lower RoE (9–10% and 4–6% respectively) and apply them on a depreciated Regulatory Asset Base, aligning returns with actual asset value. The time has therefore come to recalibrate India’s approach—by moderating RoE rates or linking them to a depreciated equity base or RAB model—so that tariffs become fair, competitive, and consumer-centric while still preserving investor confidence.