Turbulence buffets India's power sector, a favourite with investors two years ago. In the last 18 months, the Bombay Stock Exchange power sector index has fallen 25%.

One crtical threat to growth is coal shortage, exacerbated by India's coal dependency. Coal-fired plants account for nearly 70% of all power generated. Coal India and its subsidiaries, responsible for the bulk of coal production, it cannot meet the power industry's rising demand. Budget 2012 proposes welcome removal of import duty on coal. But longer-term challenge remains.

The country's power generators have been scouring the globe for coal. Last September, GVK Power acquired Australia's Hancock Coal for $1.26 billion, with plans to invest $10 billion more. In 2010, Adani Enterprises bought mines in Indonesia and Australia, while Reliance Power acquired mines in Indonesia.

Given India's deep-rooted coal supply problems, buying coal mines to secure supplies seems like a smart move. But is it the optimal approach?

A Bain & Co global market study of more than 2,000 coal mining companies and over 1,100 power utilities shows only 3% of power companies invested in mines, and of those, just 20% have a controlling stake. A controlling stake does provides some fuel security, but there are other options. Most power firms are better off employing a mix of alternatives versus purchasing mines.

High hurdles

Most power companies have avoided acquiring mining assets because of high hurdles to success. Producers must own enough quality mines in geographically diverse locations to achieve economies of scale, stable supply and compete on price. To make an acquisition succeed, utilities must overcome five key challenges.

Finding quality mines: Major mining operators such as Xstrata and Rio Tinto control most prime coal assets. The big five mining companies own 80% of the largest new projects in thermal coal. With few high-quality foreign mines available, buying mines may be risky and requires thorough due diligence.

Differing capabilities: There's little overlap in the capabilities needed to generate power and operate a coal mine. Coal mining requires specialised capabilities such as exploration and mine design - few power companies possess these.

Managing supply chains: Owners of coal mines, especially abroad, have to proactively manage their supply chains and cope with risks such as natural disasters or blockages due to political unrest. The task becomes more complex as they deal with logistics in a non-core sector.

Reducing financial risk: Coal mining is financially riskier than operating a power utility as it demands a high cost of capital: the cost of capital for mining firms is more than one-and-a-half times that for power producers. To compensate, investors are under pressure to generate higher returns from mining investments.

Recognising external risks: Finally, there are contingencies such as Indonesia's plans to impose an export duty on coal and minerals this year, followed by a total ban on low-grade coal exports in 2014, worrisome for Indian power companies or the carbon tax that Australiaplans to impoose on exports. Such curbs add to the cost and complexity of foreign mine ownership.

The right strategy

All these challenges cause most global energy producers to hesitate before purchasing coal mines. Instead, they use a combination of approaches to ensure a reliable, secure fuel supply. These are grouped in three broad categories: secure, invest and own.

Secure supply

Power generators can secure their fuel supply with options ranging from longterm contracts with domestic or foreign suppliers to spot plays. Calcutta Electric Supply Co and National Thermal Power Corp have inked long-term contracts in recent years or are pursuing such deals.

Long-term partnerships ensure power generators don't spend valuable time on non-core mining operations, while locking in a more secure coal supply. They also secure supplies by tapping the clout of a consortium. Continued requests by India's top power executives led to the Prime Minister's directive that Coal India sign 20-year fuel supply agreements with power plants.

Given the price volatility in global commodity markets, suppliers are increasingly reluctant to commit to long-term purchase agreements. But there's an option: striking agreements that guarantee availability well into the future without locking in price. For example, Japan Coal Development Co renegotiates prices annually, despite its long-term contracts.

Another option for power producers in importing countries is spot buys based on current market conditions. To be effective, they must acquire or develop sophisticated risk management techniques, and be strong players in global and regional markets, as well as form partnerships with global logistics firms.

Invest strategically

Some power producers also pursue strategic investments that provide preferential access to fuel supplies and serve as a hedge against volatile prices. Such investments take many forms, such as minority stakes in mines, equity swaps with mining companies or investment in inventories. For example, Tata Power has 30% stakes in Indonesian mines and minority stakes in tube mines in Jharkhand. While this approach doesn't guarantee pricing, it, importantly, ensures reliable supply.

Own mines, end-to-end

Instead of simply owning mines, some power companies also control a mine's infrastructure for transportation and storage. The appeal of end-to-end ownership is to minimise disruptions in the fuel supply chain. Take China Shenhua Energy Co: it owns assets across the value chain, from coal mining to transportation and power generation. Utilities considering this strategy need to determine if the benefits of mine ownership outweigh the risks. Then, they can consider a portfolio of mines to spread the risk.

These three strategic approaches - secure, invest and own - differ not only in the amount of capital required but also in the time it takes for results. Owning mines end-to-end requires significant investment, and must be in sync with well-defined strategic objectives.

Utilities must look beyond traditional approaches and adopt innovative strategies to create a secure fuel supply.

Amit Sinha is a partner and Rohithari Rajan is a principal with Bain in New Delhi.