Is consolidation the panacea for India’s CGD sector?, ET EnergyWorld

Earlier this year, a Japanese consortium comprised of Osaka Gas, Sumitomo, and Japan Overseas Infrastructure Investment Corp. for Transport & Urban Development (JOIN) invested $370 million in I Squared Capital’s Natural Gas Transition Platform. This was not the first M&A activity in the city gas distribution (CGD) space in recent months, nor is it likely to be the last in the foreseeable future. In fact, more than 50 geographical areas (GAs)—about 15% of all GAs in India—have witnessed M&A activity in the past year or so or are currently on the block. This is just the beginning of what is likely to be a spate of M&A in this space in the coming years. The interest in CGD is not surprising. As one of the world’s largest and fastest-growing economies and home to about a fifth of the human race, India is likely to see continued robust growth in energy demand over the next few decades. Combining this burgeoning energy demand with India’s aspiration to become net zero by 2070, the country’s energy mix is set to undergo a paradigm shift with an increasing component of cleaner fuels. This is where natural gas (NG) comes in, given its role as a transition fuel and being pushed by the government to increase its share of India’s energy basket from 6.7% to 15%. A major segment set to fuel this growth story is CGD, which is projected to grow at 7 to 9% CAGR over the next decade. CGD’s share in the total NG consumption basket has grown from 5% in 2014 to 20% today and has the potential to reach 35 to 40% over the next few years. With this, the sector could overtake traditional gas demand drivers such as fertilizer and power. In the wake of the successful completion of the 12th round of bidding in 2024, GAs covering almost 100% of the nation’s population would have been licensed out. However, the growth in CGD volumes has not kept pace with the licensing done over multiple rounds. The disparity between players that have built infrastructure and volumes in their GAs versus those that have not is quite staggering. The top five players currently cover about 30% of all GAs but hold 70% of the volumes and the bulk of the sector’s profitability. GasQuest, Kearney’s proprietary analytical engine that tracks the CGD sector, reveals that of India’s 300 GAs, 165 have not performed to their potential. Consider this: if all GAs had grown to their potential (in line with trajectories exhibited by the top quartile GAs), India’s CGD consumption would have been 50+% higher than it is today. Considering the emission reduction potential of natural gas over alternate fuels across CGD segments, this additional demand would have had a potential annual reduction of about five million tons of CO2 emissions—equivalent to planting about 200 million trees. An eclectic mix of factors, almost as diverse as the 60-odd operators dotting India’s CGD landscape, is responsible for this disparity. To begin with, the sector has attracted all kinds of players over the past two decades—from public sector undertakings (PSUs) and their joint ventures, private-sector energy conglomerates, and mid-sized business housed in unrelated businesses to private equity funds and international energy companies.

Many of these players bid very aggressively during the earlier bidding rounds to secure licenses, sometimes ending up giving unreasonable minimum work programme (MWP) commitments to secure the licenses. Progress after the license award has been slow, constrained by either capital, capabilities, gas supply and pricing, conflicting interests, or regulatory hinderances. Further, an increased MWP commitment to win the GA licenses has led to a significant financial burden. The sector is sitting on a ticking time bomb with current MWP penalties at ~INR 3000 Cr., which could reach INR 22,500 Cr. by 2030 if this pace continues.

This is likely to first lead to requests to the regulator/government to relax penalties and timelines (some of this is already in play), failing which the sector is likely to see distressed sales and insolvencies, especially for players that might not have the financial muscle to bear these penalties. Even for larger players with deep pockets, the muted growth and penalties are likely to burn a hole in their pockets. But that’s not all. This scenario will impact not only the financial health of the sector, but also the millions of people who will be deprived of access to clean, convenient fuel in the coming years.

However, not all is gloom and doom. A handful of players have done well for themselves, creating platforms that are poised to ride India’s CGD success story. They are well-placed to benefit from tailwinds such as the pan-India gas network development, automakers’ support for CNG, and a growing global and local investment focus while being better prepared to tackle headwinds such as rising electrification and gas price volatility.

India’s CGD space is at an inflection point, and all is set for intense M&A activity in the coming years with reasons ranging from non-performance to new entrants, investment funds looking at a profitable industry segment with potential green play, and strategic intent from global stakeholders that want to be part of India’s energy story.

The M&A approach for buyers and sellers would differ. For buyers, three possible plays are likely emerge:

● Winner takes all: Established platforms go on a proactive M&A spree, picking up nonperforming players and GAs leveraging scale and expertise to consolidate their position.
● String of pearls: Established players and platforms make strategic acquisitions to strengthen their network (for example, competitor GAs contiguous to existing GAs) or attractive one-off bets.
● Strategic partnerships: Collaborations are forged between established players and yet-to-take-off players, with the established player taking up a partial stake (likely non-controlling) to bring in expertise and capital.

On the other hand, three sell-side scenarios are imminent:

● Well-timed divestment: Players that can sense the market dynamics early on make a conscious call, in full or in part.
● Regulatory-induced M&A: The government cracks the whip on non-performers, either pushing for penalty payments or nudging laggard GAs (including PSU-controlled GAs) to take on a strategic partner or driving advocacy measures, such as ending marketing exclusivity for specific GAs.
● Fire sale: Non-performing players are pushed to the brink, leading to offloading of an entire GAasset base to a new entrant or an established player.

This presents a growing opportunity for leaders and investors to activate their inorganic muscle, find and lock in the right targets, and follow that up with projects and operations excellence to turn GAs around. As a first step, they will need to answer two crucial questions: where to play (which players and GAs to go after) and how to win (the unique value proposition being brought to the table, from standalone financial infusion or a platform play to a cluster-led synergistic play or disruptive operating models such as CGD-as-a-service.). The answer to both questions need to be nuanced at an operator or GA-level to extract the full value.

We believe India’s CGD sector could witness M&A activity of $3 billion to $3.5 billion until the turn of the decade by leveraging a combination of these plays. This will not only dramatically impact the CGD landscape but also provide a much-needed fillip to India’s CGD story, including an upside of up to 20% in CGD volumes by 2030.

To bring this to life, various stakeholders in this sector will need to address a few key questions:

Incumbents: Do I need to consider M&A as part of my CGD strategy? What M&A opportunities are relevant in the context of my GAs (buy, sell, or enter into strategic partnerships)?

Potential new entrant (strategic, private equity, etc.): What is the investment case for CGD in India (green, growing, profitable)? What are some of the potential M&A plays (strategic partnerships, buyouts, etc.) and targets available for a new entrant? What will it take to make this inorganic play a success?

Government/regulator: What regulatory or policy support will it take to drive growth in the CGD sector and spur or weed out the laggards (stronger enforcement of MWP commitments, clarity on marketing and infra exclusivity, etc.)?

To sum it up, the CGD space is at the cusp of a once-in-a-generation M&A wave, bringing with it an unprecedented opportunity to create value for all stakeholders.

• Published On Sep 10, 2024 at 03:33 PM IST

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