CASE STUDY

JAPAN There are no price controls on coal in Japan. All fuels and energy services are subject to a general consumption tax (akin to a value-added tax) at a flat rate of 5% (4% national, and 1% prefectural), as well as excise and other taxes at different rates according to the fuel.

A coal tax is levied on all final sales of coal. With respect to international market, a benchmark pricing, typically a negotiated price between Japanese steel mills and Australian producer for coking coal or between Japanese electric utilities and Australian producers for steam coal, prevails as a reference price in international market. However with the development of spot market, where coal price tends to be much lower recently, a benchmark pricing system is beginning to be influenced by spot market pricing, because buyers need toprocure coal at lower price in the face of deregulation of electricity market or international competition. PRICE SETTING MECHANISMS: DOMESTIC COAL PRICING Prices of coal products consist of various elements, such as: Mine mouth costs: labour cost, production cost, royalty and capital cost; Transportation costs: rail cost; Port costs;

Retail profit margins; Taxes and levies

Domestic coal price is determined without government intervention. The reason for setting a ceiling price is because of social consideration as to provide electricity at a low price to help lower income groups, while governments heavily subsidize coal producers to meet the difference between producer profit margin and ceiling price. PRICE SETTING MECHANISMS : INTERNATIONAL COAL PRICING There are two broad ways of setting international coal prices in Japan: long-term contract pricing and spot pricing. There are, however, many variances. CHINA
China's coal consumption peak season typically starts before the Chinese New Year. Coupled with the unusual snowstorm in southern provinces this year, coal prices in China shot up furiously within a short period of time at the beginning of 2008. In the transit hub of Qinhuangdao, major coal prices reached a record high in January 2008, up more than 20% from just a month ago, and such increases are on top of the continued uptrend in coal prices since 2004. Coal is the most important energy source in China, accounting for 70% of the national energy consumption. "Tight balance" between supply and demand The coal price trend in China is closely related to its price forming mechanism. And the reform progress in China's coal pricing mechanism in recent year has shown a clear tendency towards marketization. In the era of planned economy, coal prices were uniformly set by the government. In 1993, China started to relax sale prices for coal products other than thermal coal, which accounted for 50% of total coal consumption in China, so thermal coal price was still under a dual pricing mechanism of "planned coal" and "market coal". In late 2004, the government announced the "Coal-Electricity Price Linking Mechanism", which allows periodic electricity price increases once thermal coal price increases 5% or more in the past 6 months, and the thermal coal price in turn can be determined by negotiation between coal sellers and buyers in the market. For various reasons, thermal coal price failed to become marketised initially, but the price differentials under the dual pricing mechanism began to converge. In 2007, the 50-year-old system of government organising annual coal order meeting among coal producers, transporters and users was finally removed, and now suppliers and buyers are starting to independently

negotiate prices based on market circumstances, under the government's macro control framework. Against such a backdrop, the relationship between supply and demand has now become the major factor in determining coal prices. From a consumption mix perspective, the electricity, metallurgical, chemical and construction materials industries, which collectively account for 70% of total coal consumption, are the main users of coal in China. In the first three quarters of 2007, outputs from China's coal-fired power, coke, raw steel and cement industries had grown 16.7%, 19.4%, 17.6% and 15% respectively over previous comparable period, far exceeding raw coal output growth of 11% from the same period. On one hand, the demand for coal had been increasing significantly. On the other hand, the government were mandating the closure of small and medium coal mines and limiting the capacity expansion of coal mines, thus reducing coal supply growth. And the railway transportation in China has long been a bottleneck for coal. As a result of all these factors, demand and supply of coal in China has been in a "tight balance" situation for years. Coal prices in China started to decline in 1997 and reached a bottom in 2001. The problem of coal shortage started to surface in 2004. Although coal producers had been expanding their production in the following years, with 8.2% increase in output in 2007 alone, the supply shortage nevertheless failed to alleviate. Therefore, coal producers in China have made a windfall profit in recent years, thanks to the ever-rising coal prices. Experts predicted that national raw coal output in 2008 would be similar to the level in 2007, with about 2.73 billion tons of production, against an expected demand of 2.728 billion tons. Although there may be tightness in certain regions and coal products, China's coal market as a whole is expected to reach equilibrium this year, with coal prices maintaining at a high level. "Full-cost" reflecting resources scarcity Not only coal prices in China reflects demand and supply interaction, they are also starting to reflect the associated resources scarcity and environmental costs. Therefore, the crystallisation of regulatory costs is another important reason for the ever-rising coal prices in China. Previously, most coal mining rights in China could be acquired with little compensation, and costs of safety, environment and rehabilitation had not been included in the normal costing of coal. This not only failed to reflect the true value of resources, but also led to uncompensated resources consumption and unrecovered environmental damage. For many state-owned coal companies, they also had to face legacy issues such as rebuilding exhausted coalmines and staff re-employment difficulties.

To solve these problems, China began implementing the system of compensated use of mineral resources in September 2006, and the coal industry took the reform trial. The State Council began a pilot system of compensated use of coal resources in eight major coal producing provinces, and coalminers had to pay for the exploration rights and extraction rights. Further reforms in resource taxes and resources compensation charges are also under contemplation by the regulators in China. In addition, Shanxi Province, one of the major coal sources in China, is planning to implement a trial scheme for sustainable developments of coal companies this year. One of the important features is to levy and establish three funds, namely coal sustainable development funds, mine environmental recovery fund and coalmine redevelopment fund. And these three funds, along with mining right fees, will be included into total production costs of coal from now on. Therefore, in addition to the production costs, coal producers now have to factor in environmental, resources, ecology and redevelopment costs, hence the "full costs" of coal production. The risen costs will no doubt put pressure on coal companies. In the first three quarters of 2007, listed coal companies in China reported an average gross margin of 30.31%, down 4.82% from the same period last year, mainly because the rise in regulatory costs had exceeded the growth in coal prices in that period. Non-coal costs The increase in production costs is not the sole reason for the rising coal prices. China has a complex coal distribution chain, which had become even more expensive recently, so these non-coal costs are also responsible for the rising coal prices in China. It is understood that sea freight contract prices for coal has increased from 40-50 yuan per ton before 2007 to the current price of 100 yuan per ton. The "coal-power tension" between coal producers, power generation plants and power distribution networks, which are all acting in their self-interests within the value chain, has long attracted the public attention. While the coal prices continued going up in January this year, the government didn't accordingly increase electricity prices as per the "Coal-Electricity Price Linking Mechanism", due to macro control considerations (on inflation). In this circumstance, the thermal coal price became a tenacious point between coal producers and power producers. Experts suggested that the improvement in coal pricing mechanism in China needs to progress alongside reforms in related industries such as power generation, railway and ports. Furthermore, China is now facing an upward pressure in general prices, so stabilising prices and preventing serious inflation will be the main objective for macro control. An effective coal price setting mechanism should not only observe the principle

of market economy, but also take into account the government's macro control theme and affordability of downstream industries.

KOREA The wholesale and retail prices of oil and bituminous coal are completely deregulated. The wholesale prices of domestically produced anthracite coal and briquettes are set by the government as part of a subsidy to support uneconomic mining. Gas and heat prices are controlled directly by the Ministry of Commerce, Industry and Energy (MOCIE). The Korea Electricity Commission (KOREC), a quasi-autonomous body within MOCIE, is responsible for regulating KPX and final electricity prices. Final decisions are made by MOCIE following the rulings or deliberations of KOREC; in practice, the minister does not usually overrule KOREC.Korea imposes import duties on crude oil and refined products; the latter are taxed more heavily, providing a tax advantage for Korean refineries relative to product importers. Bituminous-coal imports also carry a duty. A flat-rate VAT of 10% is levied on all sales of fuels and energy services. Excise taxes are levied on oil products and gas sales to both households and businesses; transport fuels are also subject to additional taxes, including an education tax and an array of transport taxes (so-called traffic, energy, and environmental taxes). Government support to fossil-energy production concerns mainly coal. Support to producers of anthracite coal has been in place for several decades, involving price support, subsidies for acquiring capital equipment, subsidies for exploration, and support of a more general nature. The price-support component was repealed at the end of 2010. Direct investments made by the government and public funding related to research and development by KCC and KORES were halted earlier. The government also provides support to the production of anthracite briquettes mainly by setting the price below cost (to protect low-income households) and paying the difference to producers. Support is due to be phased out progressively and terminated by the end of 2020, though a scheme to provide vouchers to subsidy consumption is expected to be expanded to offset the impact of higher prices.The government is also planning to introduce funding for a project to develop clean coal-technologies that is planned by SK Energy (Koreas largest oil refiner) and Pohang Iron and Steel Co (a domestic steel maker). The government already provides funding for research and development projects related to exploration technologies for oil and other mineral resources, as well as to integrated coal gasification combined-cycle (ICGCC) technology as part of its renewable-energy research programme. The Korean government also encourages private exploration and production overseas through tax benefits and the extension of credit lines to domestic companies by the Korea Export-Import bank. Consumption subsidies concern mainly excise-tax exemptions for various fuels and categories of consumer. These include exemptions for farmers, fishing boats and certain types of coastal passenger ships from the various taxes that are usually levied on sales of oil products; exemptions on sales of anthracite coal and briquettes from VAT (as well as price controls as described above); and grants to disabled persons and so-called state meritorious persons to cover the increase in fuel prices since 2001.

Coal India Limited (CIL) has migrated to a new system for pricing its non-coking (NC) coal on the basis of Gross Calorific Value (GCV) w.e.f. from January 01, 2012. Till December 2011, the company used to follow the Useful Heat Value (UHV) based method to price its NC coal. The revised mechanism is more in line with the international system as against the previous mechanism, which was an old method and depended on moisture and ash content through the application of an empirical formula. ICRA's analysis shows that prices of certain grades of NC coal may rise significantly under the new price regime, while for certain other grades, prices may actually decline. Prices of coking coal would not change under the new mechanism. The revised pricing system has divided the entire spectrum of GCVs into 17 bands, from 2200 kilo calorie per Kg (KCal/Kg) to 7000 KCal/Kg and above, in intervals of 300 KCal/Kg, as against 7 grades (A to G, from 3200 KCal/Kg to 6400 KCal/Kg and above) that had existed under the previous UHV based pricing system. Additionally, CIL has brought in a uniformity in the pricing of NC coal produced at different mines of different subsidiaries, as against the earlier practice of subsidiary-wise and mine-wise differential prices. Only coal produced from ECL would command a 6% higher price over the prescribed notified rates. For notifying the revised price bands, CIL has continued with its broad classification of consumers; viz. power/fertiliser/defence (core sector) and the rest of the industries (non-core sector). However, the price difference between the core and non-core sectors has now been revised upwards. Under the UHV based system, D, E and F grade coal for the non-core sector had a price premium of a flat rate of 30% over the same for the core sector, which now varies between 33% to 60% under the new GCV based pricing system. Impact Analysis Since CIL has a near monopoly position in the domestic coal market, with a market share of around 80%, the new prices would be applicable to almost all NC coal consumers in the country. ICRA notes that the migration to the GCV based system would lead to different price increases for different grades of coal, and therefore the impact on various companies' coal costs would also be different. In the absence of adequate data at this stage on CIL's product mix across the new GCV bands, it is difficult to arrive at the exact impact on various coal consumers. However, a study of the revised price bands enables one to make a few critical inferences as listed below. For the analysis, ICRA has considered the extent of price increase from the lowest and highest price levels prevailing in each of the earlier grades, and has also calculated the same from the middle level. Price of erstwhile A, C and D grades of coal are likely to be impacted significantly. Cumulatively, these grades contributed around 19%-23% of the total NC coal dispatch volumes between 2006-07 and 2009-10. Additionally, within each of the grades between A and D, the price would increase the most in the

highest GCV band for that particular grade, and would decrease progressively along lower GCV bands within that particular grade. Prices of the medium grades (C and D) are likely to increase quite steeply. A significant proportion of this coal is used by non-core industries including sponge iron and cement. As per quick calculations, coal costs account for around 25% of the total operating costs of a sponge iron manufacturer having 100% coal linkage from CIL (this would however vary, depending upon factors like the distance of the plant from the coal mine). Similarly, the share of coal costs in the total operating cost of a cement player would be around 30% (cost of power could be another 15% or so from a coal based captive power plant, if the cement plant has any). Consequently, a sharp increase likely for these two grades would impact the cost structure of sponge iron and cement players significantly, more so since prices are higher for the non-core sectors. Nevertheless, ICRA notes that given the coal shortage scenario that has been prevailing in the country in recent years, many non-core players were dependent anyway on costlier coal procured from e-auction and/or imports, and the overall impact of the revised coal price on their cost of operations would be limited to that extent. The power sector is the largest consumer of NC coal, accounting for around 73% of CIL's volumes in 2010-11. The impact on the power sector, which is the primary consumer of E and F grade coal, is expected to be mixed. The price rise could be quite sharp for the highest GCV bands within the E and F grades. However, moving towards lower GCV bands within E and F grades, the effect would be mixed across various collieries. Consumers which were procuring E grade from Western Coalfields Limited (WCL) and F grade from Eastern Coalfields Limited (ECL) at higher prices earlier would now stand to benefit if they get to procure coal from the lower GCV band within the respective grades. For other consumers, the impact would be adverse. However, many power producers buy higher grade coal for blending with the inferior E and F grades, and the overall impact on their fuel costs would be impacted because of the rise in the prices of coal in the grades A to D. Captive power plants would not be eligible for being classified under the core sector. Consequently, power costs of companies in energy intensive industries including primary aluminium, cement and steel, many of which have coal based captive power plants, primarily using E and F grade coal, would witness some pressure on their production costs going forward, especially considering the fact that the premium for the non-core sector consumers have been increased under the revised system. For instance, power cost would typically account for around one third of the total smelting cost of a primary aluminium producer, and an increase in coal costs would exert pressures on its profitability of operations. Core sector consumers of Mahanadi Coalfields Limited (MCL), South Eastern Coalfields Limited (SECL) and Northern Coalfields Limited procuring C, D and E

grade coal would be impacted to a greater extent, since in the previous regime, prices of coal for the above grades charged by these three mining companies were lower than the same charged by the other four subsidiaries of CIL. The revised pricing mechanism being uniform across coal mining companies, the extent of price increase for these consumers would be relatively higher. CIL is currently in the process of ascertaining the GCVs of its coal produced from different collieries, and ICRA expects the revised prices to be implemented once this process is concluded. Despite the possibilities of substantial price hikes for various coal consumers as explained above, ICRA notes that the possibility of grade slippages remains following the completion of the GCV estimation process, in which case the extent of price rise for a particular coal mine would be moderated to an extent. A clearer picture would only emerge once CIL comes out with the results of the calibration exercise. ICRA would continue to monitor further developments in this regard and evaluate its impact on the profitability of consuming industries.