The IPP negotiations

THE short-sightedness in dishonouring sovereign contracts will haunt us. The government is guaranteeing high power generation costs for years to come. The private sector began participating in capital-intensive power generation projects in many developing countries in the 1990s, as governments had limited fiscal space to invest in them. So, independent power producers were set up. In a few years, IPP payments became a burden in these states, where increasing generation capacity was the sole policy aim. The power sector became untenable without simultaneous demand management and lack of reforms in transmission and distribution. The expanding generation capacity rarely coincided with industrial and economic growth.
Most of these countries had poor credit ratings, high investment risk, and issues with the electricity sector. To attract private investment, the policies needed generous terms and high returns. Governments provided sovereign guarantees to secure the contracts. The agreements were made under international law, with dispute resolution through international arbitration fora. Pakistan set up IPPs under similar policies. The four power policies of 1994, 2002, 2006 and 2015 promoted negotiated tariffs on a cost-plus basis and a guaranteed return on the equity invested. Nepra assessed projects’ capital and operational costs and awarded tariffs based on that.
The power tariffs are two-part. The first part is capacity tariff, including debt repayment, fixed O&M and insurance costs, and return on invested equity. The second is the variable tariff, including fuel and variable O&M costs. The latter fluctuates based on fuel prices and plant utilisation. Banks typically financed 80 per cent of project costs with 10-year loan tenors, so the tariff is high in the first 10 years and lower for the remainder of the project’s life.
The cost-plus tariff used in the policies was ineffective in discovering market prices. There is information asymmetry between market players and regulators. Cost-plus tariffs should have been limited to the first few projects in 1994. Once the private sector’s confidence was won, procuring generation capacity should have been done through competitive bidding. However, when the power policies were announced, the government was in a hurry to build new power projects and continued with the inefficient tariffs. In 2015, private investors and IFIs showed little interest. Regardless of cost implications, the government wanted power plants before the 2018 polls and invited Chinese companies who insisted on an upfront tariff for setting up the projects.
This tariff is even worse than the negotiated one in determining market prices. It is also calculated on a cost-plus basis, but the regulator assumes the costs with a built-in return on investment. The upfront tariff was used for renewable energy projects. At the government’s insistence, Nepra assumed high costs to determine the upfront tariffs for coal power projects and the transmission project under CPEC. The tariffs were overly attractive as the actual costs are likely two-thirds of the assumed costs. It was a policy and regulatory failure dictated by political expediency, unnecessary urgency, poor planning, and inadequate investor interest.
Three events since 1994 have hurt international investor confidence. The first was the government’s coercion of IPPs and the unilateral change in Hubco’s tariff in 1998. Then there was judicial intervention in rental power projects under the ill-conceived policy for rental power generation. The agreements with IPPs were renegotiated in 2020, and the IPPs agreed to change the terms of the contracts voluntarily, although not legally obliged to do so.
This week, the cabinet approved the termination of IPP contracts, and the PM announced that more IPP contracts would be revised. We’ve already paid the price of a poor investment climate through CPEC projects and have no case to argue except to request debt rescheduling. The Hubco episode and judicial intervention in sovereign contracts had already eroded investor confidence, and forced renegotiations will end any chance of rebuilding it.
The 2020 report on the power sector, authored by the incumbent SAPM on power, precipitated the power contract negotiations. The report was flawed. It conflated issues, entertained conjecture, drew wrong conclusions, and missed the policy perspective. The IPPs were set up under government-promulgated policies overseen by the regulator. We must endure the cost of our mistakes and avoid making more. Blaming private investors for government policy blunders and regulatory weaknesses is ridiculous. This is not to say that corporations involved in power generation have done no wrong. Over-invoicing, tax evasion, regulatory gaming, and misreporting are common in corporate sectors globally. Some IPPs have likely committed corporate crimes. Regulators should probe and rectify regulatory errors, if any, and prosecute the perpetrators if evidence is available.
Briefly, we need private investment in the power sector and low-cost electricity. We need to move from cost-plus tariff to competitive bidding. To have low-cost power projects through competition, we need high investor interest, confidence in policy stability, trust in contracts, and low investment risk. In 2022, Nepra approved the generation capacity expansion plan. It aims to add 20,000 MW of new solar, wind, and coal capacity through private investment by 2030. The policy objective should be to procure the required capacity at the least cost through international competitive bidding.
Governments should take a strategic view, follow a vision, make policies for growth, and aim to reduce the cost of essential services. What the government is doing today will, instead, ensure that we continue with poor tariff regimes, pay hefty premiums, offer higher returns, and provide stringent guarantees by international institutions to attract private capital in future power generation or other public-private partnership projects. The savings from reneging on sovereign commitments are minimal, while the losses will be incalculable.
The writer is a former member of the Planning Commission.
Published in Dawn, October 12th, 2024