Special editorial feature 
 

Special editorial feature

Private Investment in the Power Sector

a Different Route

By Dr. Shahid Rahim | August 2020

The IPP issue has taken center-stage in Pakistan yet again, with the government accusing them of fleecing the nation by minting billions by way of profits while the IPPs vehemently deny this. Experts on both sides of the fence must be left to wrangle out the extent to which these allegations are true, if at all, and who has actually been responsible for this alleged abuse — the IPPs, the sector managers, or both? Our focus is only on why the IPPs end up in such controversies every few years and how such conundrums can be avoided in the future. But, first a few words about the electric supply industry itself.

Most people expect electricity to be available to them on the flip of a switch. Few, however, realize that to provide this control and flexibility to its customers — day in and day out, under scorching heat and bitter cold, during heavy rains or choking dust storms — the electricity suppliers have to make tremendous investments in generation, transmission, distribution and allied facilities. Power systems are among the most complex and expensive of infrastructure facilities for any country, but are a lifeline for their economy and society. Electricity is also a unique product. It must be produced and delivered, the moment it is demanded, as its large-scale storage is very expensive, if not impossible.

Three features of the electric supply industry stand out: (i) it must maintain sufficient power generation “capacity” in the system to meet any reasonable demand on the system, regardless of its location, timing and duration; (ii) it must keep at hand adequate resource supplies (fuels, water, nuclear, solar radiation, wind, etc.) to serve the consumer’s’ “energy” demands (the electricity consumed by their machines and appliances); and (iii) it must design and deploy each component in the system carefully to deliver electricity to consumers “reliably” and within a tight band of “quality”.

The electric supply company is a capital-intensive enterprise, often involving billions in investment upfront and also during operation. Roughly, 60% goes to generation facilities, 15% to transmission systems, and 25% to distribution networks and services. A 1,000 MW power plant alone can easily involve over a billion dollars of investment upfront. The generation and other facilities in the plant are not independent of each other but are tightly interlinked. Any disruption in fuel supplies upstream or demand downstream can cause billions invested in the system to become stranded, leading to bankruptcy of the utility.

When power sectors of many countries around the world were opened to competition in the late 1980s, there were two key motives behind the move: (i) share the financial burden of the sector’s capital-intensive schemes with the private sector; and (ii) subject it to the discipline of private markets, to remove the rampant inefficiencies in the industry. However, when the generation part of the electric supply was opened for private investment, complex policy packages based on attractive return on investment, long-term commitments, guarantees (including the infamous “take-or-pay” contracts), and risk sharing had to be introduced, as without these, no commercial creditor would lend capital to sponsors of such projects.

Even in developed economies, efforts to invite private investment into power generation projects being set up on the concept of merchant plants (“take-and-pay”) did not meet any significant success and some long-term commitments and guaranteed off-take by power purchasers had to be assured to lure private capital into such high-risk projects.

Though, private investment in power generation projects via long-term contracts met with success in most developed countries, developing countries, including Pakistan, could not replicate this success. The reasons were mostly the lack of business-friendly environment, uncertainty of government and regulatory policies, and absence of a favourable institutional setup. A supportive environment was either already there or was created in developed countries, in sharp contrast to developing countries where such an environment did not exist and could not be created for a variety of reasons. This lack of security, uncertainty, and high-risk contributed to investors either shying away from investing or demanding hefty returns and shorter debt tenures for their investments.

Pakistan also joined the IPP bandwagon in the early 1990s with the introduction of a formal private policy package in 1994 that offered multiple incentives and guarantees to private investors. Since then, almost 19,500 MW of private power generation capacity has been added to the grid; this constitutes roughly 50% of the total capacity today. Most of this IPP capacity was obtained via the “take-or-pay” style power purchase agreements (PPAs) in addition to other security instruments.

According to the latest draft Indicative Generation Capacity Expansion Plan (“IGCEP”) of the NTDC (April 2020), over 50,000 MW of new capacity will be required by 2030 to serve the forecast demand of 44,000 MW and replace 6,500 MW of to-be-retired existing capacity. In this requirement, 14% is already committed to CPEC projects, 20% to public sector projects, and 13% to private projects. Roughly 53% (or 27,000 MW) of new capacity requirement is still not committed and is thus open for private investment.

Unfortunately, since introduction of the first private power policy in 1994, the legal, regulatory and institutional environment considered essential for healthy private investment in the power sector has not improved and in fact has deteriorated. One, therefore, doubts that the country will be able to attract future private investment on a “take-and-pay” type contracts. Willingness of some investors to accept “energy-only” contracts for solar and wind projects cannot be replicated for the conventional IPPs, because solar and wind plants, due to their intermittent and variable nature, hardly contribute to a firm capacity which is essential for maintaining grid reliability. This limitation only shifts their capacity costs to the hosting grid.

Fortunately, the world’s energy market has taken a favourable turn recently that we can use to gradually phase out our dependence on large-sized and capital-intensive generation facilities and reorganize our electricity supplies on a more decentralized and distributed grid. Small plants, both conventional and renewable, have emerged that beat the cost and performance features of large plants. Such plants can be installed nearer to the end-users of electricity, are not capital-intensive and can help avoid the T&D investments that are normally required with central-station conventional power plants.

These developments open a big window of opportunity for private investors, also because the smaller sizes of such projects make them less capital-intensive and thus less risky. The only issue is their small-scale, distribution nature and novelty that may deter private investors who normally prefer to invest in projects that are concentrated in one place and for which time and market-tested financial mechanisms and instruments are already available.

The Pakistan government can do a lot to encourage private investment in these projects by providing a business and investment-friendly legal and regulatory framework, some special funds and a supportive institutional setup. The payoff to the nation will be huge and sustainable as these investments will set into motion a virtuous cycle of local industrial development, employment generation, reduction in pollution, and lessening of dependence on imported fuels.

Investment is such schemes will also further enhance competition in the electricity supply situation that currently tops the list of power sector reform agenda that the government is pursuing with assistance from multi-lateral development banks. As aptly noted by Alfred Kahn (author of the monumental treatise, The Economics of Regulation), “Whenever competition is feasible, it is, for all its imperfections, superior to regulation as a means of serving the public interest.”

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