Upfront Wind Tariff-the issues

NEPRA has recently announced an upfront wind power tariff .In this space, we would attempt an evaluation of the scheme as announced, and apprise the readers of its pros and cons. First of all, let me explain some technical terms, which may not be readily intelligible to the lay reader. There are many types of tariff schemes; for the purpose of generation tariff, the following two types are relevant for our discussion. One is cost-plus, which means, the producer/seller IPP is paid its actual cost plus an agreed profit by the power purchasing company. Practically, it is almost risk-free to the seller, as all seen and unforeseen costs are paid for in this scheme of things including escalations of all kind, interest rates, foreign exchange and inflation. Determination of this tariff poses great responsibility on the shoulders of regulatory authorities, as the true costs have to be determined, in the face of the seller having a natural tendency to overcharge. In developed economies, cost-plus is mostly outmoded, as energy/electricity price is determined through market forces as these operate on energy exchanges, where electricity price is determined in an auction manner of a typical stock exchange. In Pakistan, this disease of booking unfounded cost has acquired unmitigated dimensions. The other tariff type is what we call an upfront tariff. This is also called a feed-in-tariff these days and is also being practiced in the West, for the purpose of promoting investment in the renewable sector. Under this scheme of things, regulators do their own investigations into the costs and competitive tariffs, and announce a tariff which aims at enabling the investor to recoup its investment and get an attractive return. In many developing countries (Brazil, Turkey and India and many others in Asia), this type of tariff has been determined through auction. This indeed is an ideal market based arrangement, which could also have been adopted by our decision makers. More on this is to come later.

NEPRA has approved a wind power tariff of 14.66 cents (Pk. Rs. 12.61) per unit levellised at 10% discount rate(We have seen tendency at NEPRA to compute levellised cost at a fixed 10% irrespective of the average cost of capital at which rate discounting ought to be made; more on this later).In actual terms, in the first ten years the tariff has been fixed at Rs 14.81 per unit and Rs.6.8977 for the next 11-20 years. Bad news for those who think, wind is free or cheap. It is elsewhere, but not in this land of pure. Today, in the US, Wind electricity is the cheapest at 5-6 cents, cheaper than any other alternative, fossil or renewable. In nearby India, it is IRs 3.50 per unit (1 Indian Re equals to Pakistani on the average).In Brazil and Turkey, it is has been auctioned recently at 7 cents per unit. In Germany, it is 10.61cents and lower and in Spain at 7.85 cents. NEPRA has itself in the past awarded tariff ranging between 9.5 and 10.50 cents, since 2006. Wind Turbine costs had increased in the intervening period with the hike in commodity price 0f 2008. However, in recent years Wind Turbine costs have come down by more than 20%.In Europe, Wind Projects (all costs including Turbine) cost around 1800 USD per kW and In India and USA, the same are at 1200 USD per kW, as opposed to USD 3000 per kW implicit in the upfront tariff of Pakistan and in other cost-plus tariffs awarded by NEPRA.

Source:NEPRA

In some respects, there is an improvement, as the Wind Risk clause has been practically eliminated. This was a relic from the past, when bankable wind data was not available in Pakistan. Now the data is abundant, reliable and bankable. Operational problems would have been there in implementing the wind risk, as underperformance of turbines, it was likely, could have been booked under wind risk. At times, it becomes difficult to distinguish. The new scheme under demand of stakeholders, does maintain an element of Wind risk issue in a guarded and circumscribed manner. Also, there is a provision of escalation on the lines of cost-plus schemes where in exchange and interest rate variations, and other inflationary formulae have been built in, making it almost as bulky as cost-plus regime. In India, there is no escalation and the tariff is denominated in Indian Rupees 3.5 per unit, not a lot of money to play around and to build in escalations. In Pakistan, Inflation is generally high and currency depreciates faster than it does in India. I wonder, if Wind tariff is denominated in US dollars at 12-14 cents(with out escalation ,which is taken care of by the average 5% currency devaluation per year in the long run)would have been more handy and simple. One has to study the option for its implication on both the sides. On the issue of Green Credits, there is confusion; at one place, it awards the same to the power purchaser, while at other reference is made to GOP policies. Under other schemes, Green credit is to be shared among buyers and seller equally.4) this very attractive tariff is to remain valid for the first 1500 MW and for projects that achieve financial closing before the end of 2012.

Most of the times, I have been expounding the public perspective and vantage. An affordable and payable tariff, in my view, is the only guarantee that investments would be paid back with a fair return. Excessively high tariff may not be able to attract investors, as some hope that they may queue up for this kind of return as permitted by the announcement of 15 cents , perhaps the highest ever in the world. I do sincerely hope that investment does come in and we do not become a victim of double jeopardy, low investment that would have come any way and high tariff.

We have to think about reducing the energy costs and tariffs. The earning power of our people is low and there is 30% populace living under extreme poverty line. At least, it should be competitive with other countries of the world and the regions, and not 50-100 % higher than elsewhere, as the data provided earlier indicates. Overbooking the capital costs and its institutionalization in the upfront tariff is part of the problem, although a major one. Most power projects are foreign funded in debt, if not in equity. Large projects may have majority or 100% foreign equity. Foreign debt is priced at LIBOR+3% usually. After the law and order conditions improve, this mark-up may be halved in line with other countries of the region. More crucial may be the local debt, which is unaffordably high, either for industries or power sector. One wind project has asked for KIBOR+6%, which jacks the interest rate to 17-18%.In India, Power Finance Corporation charges 12% on the average, elsewhere interest rates for power sector are even lower. Except for working capital and local construction costs, it is arguable whether permitting local currency financing is the right policy. Keeping in view the enormous investment requirements of the power sector in the coming two to three decades exceeding one hundred billion USD, consideration may be given to set up a specialized financing institution on the lines of Power Finance Corporation India. Already, it is emerging on a small scale as can be seen by the initiatives of some institutional financial companies like EOBI. Renewable energy, which is the future of energy and not a very distant one in that, poses special problems; fuel costs are zero, but the capital cost may be higher. Viability of these projects is very sensitive to the capital costs, interest rates and rates of return to equity investments. RoRs of 17-18% are simply not feasible and affordable, as the impact of these rates on unit production cost is almost twice as high as it is in the conventional energy sources.

Another important aspect that should not escape the attention decision makers is the promotion and support of local content in the imported turbines. It may be unrealistic to expect 100% local manufacture. A deletion Plan on the lines of automotive sector may be developed, building incentives for the local content. Eventually, the cost of incentives would be eventually paid off by the ultimate cost reduction and employment generation effect. There is a lot of unutilized capacity in Pakistan which could be put to use through partial local manufacture. Turkey is a recent example where local content based wind tariff has been introduced. One would be able to support such a high upfront tariff of 15 cents (levellised/average), had it been based on a local content basis.

NEPRA determination appears lacking in transparency. The determination, as posted on the website, talks of all other issues but the main issues. All that has been disclosed is a table providing O&M costs, Return on equity and debt servicing component. There is no discussion or revelation on the bases on which the determination has been made. Is it market based or cost based. It cannot be market based, as it is 50% higher or even more than any other tariff, either in the region or internationally. If it is cost based, the main issues of Capital Cost and cost of capital should have been discussed and dealt with. It has been clearly avoided, which is unfortunate. One notices a trend in NEPRA proceedings and recent determinations of curtailing and avoiding the main issues, at least from consumers’ perspective. Sellers’ perspective, concerns and queries are addressed only. There are hardly any interventions representing the contra point of view. Is it general apathy or a deliberate policy on the part of NEPRA to discourage diversity of views and opinions expressed? NEPRA should make every effort that its proceedings do not appear one sided and that there is adequate representation. Clearly, all points of view cannot be accepted and adopted. However, there has to be an adequate acknowledgement and the reasons for rejection and acceptance of those. For example, why does one think that a capital cost rate of 3.1 Million USD per MW (a figure that appears to have been used in arriving at the 15 cent’s tariff) is justified which is almost twice the prevailing cost for the similar equipment in the region and elsewhere?

Concluding, it is hoped that some projects would come on stream under this excessive tariff .Reportedly the government has given a target of 500 MW in this respect, which may not be an impossibility. After this immediate period, hopefully the country may adopt an auction based competitive system which may result in a better deal for the country. Finally, there are many lose knots that have to be tightened in the energy sector. The symbiosis between fuel and electricity is to be recognized through integration of policies and institutions, be it through mergers or through other policy and administrative instruments.

The writer is the author of “Issues in Energy Policy” (in the press).

Re-organisation Of electrical sector; the closure of PEPCO

Reorganization of Electrical sector: closure of PEPCO issue ?

Contradictory reports are coming in regarding the closure of PEPCO, which was created a few years ago in the wake of restructuring of WAPDA. Earlier WAPDA used to be the sole organization, responsible for the power sector, which was a continuation of an early power regime, where hydro power used to be a major component of the electricity supplies. Reorganization was done as under; WAPDA restricted to the dams, irrigation system and the hydro generation facilities like Tarbela etc. WAPDA happened to be the owner of these assets and facilities. PEPCO was given the ownership and management of Power distribution companies (DISCOs) and possibly the thermal generation plants. NTDC (National Transmission and Dispatch Company) was to own and manage the Transmission facilities and act as an integrated system operator (ISO) responsible for power dispatch management. There is a CPPA (Central Power Purchasing Authority) under NTDC with a low profile, which bought electricity from all the IPPs and GENCOs and sold it to the distribution companies (DISCO). The need for this arrangement was felt because of a uniform tariff regime system, under a huge subsidy. The whole system except for KESC and other IPPs was in public sector.

Under a Power Utopia, the entire power sector would be eventually privatized, there would be no subsidies and there would be separate regional or DISCO tariff and thus no WAPDA or PEPCO. Two developments have taken place recently. CPPA has been upgraded from a section under NTDC to a full-fledged company under GOP guarantee. Perhaps this was a step in the right direction. It had to be a guarantee company because, it would be entering into power purchase agreements, that had to have the benefit of GOP guarantee for the satisfaction of investors and IPPs. It is being wishfully contemplated by the Power theorists of multilateral agencies under which all reform is being engineered that the subsidies would go away along with the uniform electricity tariff in the country.

The whole electricity sector has been structured under a unified model of uniform tariff and central investment. All assets and fuel sources have been developed under it. Power sector, under 18^th amendment has become a Federal subject, rather than being on the concurrent list as it was earlier. Subsidies may go, but a regional tariff is impossibility due to the baggage of the past. In a decade, the sector configuration may change appreciably due to increased contribution of IPPs. Regional tariff may then be a possibility.

Nationalists of KP, rightly or wrongly, already allege that cheap hydro electricity is bought from Tarbela, and sold back to the province through PESCO at a rate many times higher. They, however, forget conveniently that, it is the federal investment through which cheaper hydro electricity is produced. KP contribution it is of its location, which is rewarded under a royalty system. Except in Punjab, the electricity losses are 30-40% which is largely taken care of by subsidies. These subsidies are assumed by GOP were never paid off timely resulting in circular debt which leads to shortage of liquidity in the system and low capacity utilization in a situation of power shortages. The theft in Punjab is at its lowest of 15%. If regional tariff is introduced, Punjab as a whole would benefit, which in effect subsidizes the more theft prone regions of the country. Under go alone system, it would probably have a lower tariff. The utopia may, however, have some chance if all resources are priced at their true value or market worth. Natural gas according to this theory is currently underpriced and thus its price /tariff should go up.

All of this can lead to a political disaster, threatening and risking not just the sustainability of democratic system, but the very foundation of a united federal Pakistan. Federalism is popular under which the political actors and the system is ready to get rights and not the responsibility. Let the people get the putative merits and advantages under the new system for a while, and then the requisite burdens and liabilities may be shifted. No wonder some rebalancing may be demanded later.

Coming back to PEPCO, its role and its rationale, in Pakistan an administrative model has worked satisfactorily in the past of sectoral corporation controlling and administering the sectoral companies. As in the manufacturing sector, the privatization took place these corporations went away, as has happened in the case of PACO, Ghee Corporation and others. The Corporation model is of a holding company that serves as a professional intermediary between the public sector companies and the bureaucracy of the ministry, obviating a direct role of the latter in the day to day affairs of the companies. These corporations are also supposed to take care of the sectoral issues and its development, suggested policies and advised government. However, the enterprise/company management has often complained of a rigid control by these corporations, hampering their management independence and flexibility. The notion is sometimes supported conveniently by the ministry bureaucracy who wants direct control without intermediaries of the corporation. Opposition to PEPCO is to be seen in this perspective, although there are genuine issues of reconciling the roles in face of a rejuvenated CPPA. The role of a sectoral corporation and a holding company would be there in the background of the aforementioned issues. There may be no role for it in a Utopia and a totally privatized regime, which time has not arrived yet.

We cannot possibly afford to be reckless theorists unmindful of the consequences of policies and new regimes. The foreign advisor and theorists do not buy the same medicine for themselves as they prescribe for us. Had they done so, there would have not been much of an inefficient manufacturing sector in their countries surviving on trade barriers .Even agriculture survives there on trade barriers and subsidies. Inefficient and labour intensive sectors would have been long shifted to this part of the world promoting mutual welfare and employment in labor surplus economies. This has not happened and would happen very gradually, minimizing dislocation on the part of adjusting people, labor and sector. Same gradualism would be advised here and not the abrupt actions under the knife of IMF and dagger of project loan giving agencies. PEPCO may be allowed to continue or merged with CPPA.

KESC Tariff difficulties;Shun constant Tariff formula

There seem to be difficulties again with the implementation of a rather unique tariff system given by foreign privatization consultants. I have not been closely following KESC tariff issues over the past many months.However my cursory following indicates to me that there are implementation issues involved in KESC tariff.There was earlier some kind of a divide on KESC issue at NEPRA board ,wherein two of the honorable members either wrote a note of dissent or withheld signature altogether.Now there are difficulties in awarding fuel price and O&M adjustments.NEPRA member Tariff,who reportedly presided over three member public hearing on KESC tariff,ordered physical verification of fuel expenditure invoices from the KESC. Let me give the reader some background on the tariff setting systems.

There are broadly two system:one of cost-plus,where all costs of the utilities are paid as these occur,and a fixed or variable Return on Investment(ROI) or Equity(ROE) is paid,generally related to the on-going interest rates.All IPPS are paid based on this cost-plus approach.There is a reference tariff determined through regulatory process,escalation above which is provided based on agreed formula and current fuel and other variable prices.It is relatively fair and simple.In case of distribution companies,with highly depreciated assets and often negative equity,Return on Asset(ROA) approach is used.OGRA is also doing the same with the gas distribution companies.

In case of KESC , a constant price tariff approach was adopted,however,with provision of escalations.The difficulty with KESC is that ,it is an integrated utility,with generation,transmission and distribution.Electricity is self generated by the KESC and is also supplied from WAPDA network.At the time of privatization, a certain mix of self generation,and purchase and an assumption of oil/gas mix was made.Depending on such assumption, a reference tariff was given with provision of escalation.At that reference price, there was an implicit loss to KESC, and the expectation was that the new KESC management would make the required investment and essentially earn through loss reduction.There were and still are Transmission and Distribution losses in the KESC system more than if compared with the

public owned companies like LESCO and IESCO etc.Also the thermal efficiency od most of its plants is very low,wasting a lot of expensive fuel oil.KESC has done some investments and is in the process of making more investments towards improving thermal efficiency and saving fuel cost.This saving ,however,will go towards reduction of losses,wiping out the accumulated losses and finally towards return on investment.These savings cannot be passed on to the public as some people seem to be demanding.

However the existing system of constant price with escalations has become very cumbersome and even lacking in terms of transparency due to its complexity.Traditionally,this constant price formula has been used in distribution companies only, and that also for up to three years,with no provision for escalation.

In most of the developed world, electricity generation is out of regulatory process.Whole sale electricity prices are set through demand and supply through an auction process through electricity exchanges on the lines of share bourses.Generation prices are relatively more stable in the OECD countries as most electricity generation is based on gas,coal and nuclear power,where price volatility has been lesser.Even in the neighboring India,the electricity prices are much more stable than here,due to the domestic and public controlled coal.In Pakistan,hydro and gas based electricity used to provide price and tariff stability,but due to increasing contribution of oil based generation.price volatility has increased.This oil dependence and the increasing trend on oil dependence is the single largest threat to Pakistan's economy and social stability.The earlier other sources such as hydel and coal are utilized the better.

Coming back to KESC,the very purpose of constant price system of offering simplicity and transparency seems to have been defeated due to so much variability and complexity.It is quite possible that the young men at NEPRA who do these calculations may sometime fail to appreciate the issues and commit mistakes.Even this writer often gets confused and finds himself at a loss as to how to separate permitted variabilities from the non permitted ones.The situation would get even more complex and complicated if and when KESC makes new investments in new generation capacity.Questions have already been raised by the stake-holders,casting doubt and feeling confused.

Our business community,which is not used to spending money on building institutional capacity in their representative organisation,has never managed to make a technically valid case and has relied more on delaying litigation to oppose tariff increases.If nothing else ,the KESC tariff system is becoming too cumbersome to be transparent.Recent load balancing practices and requirements ,and the consequent changes of oil and gas mix have further complicated the situation.

It would be only appropriate that the government and the regulatory bodies consider changing the KESC tariff system to a conventional simpler system of Cost-plus,which is being practiced with other IPPs ,and distribution companies.Even KESC management may feel at ease, if the stake-holder confidence in the system is improved.For this to happen,KESC tariff has to be a three part tariff, separately for generation ,transmission and distribution.In this case comparability with other similar companies would be available preventing abuse or error.This would be for regulatory body and the KESC: public would be having one tariff as usual and would not be burdened with such disaggregation.Foreign consultants as usual are to be appointed,as the requisite expertise and objectivity may not be available locally.

Targeting loss reduction and basing tariff on it is to make tariff contentious,controversial and fluid.KESC tariff system has this feature as well.It has been demonstrated now that the private sector has no special leverage in reducing T&D loss reduction.most of which is theft and pilferage.In fact private sector is susceptible to political and group pressure more than the government functionaries.As to the reduction of fuel cost and increasing thermal efficiency,it is a matter of attractiveness of investments in the sector and tariff stability.Third party investment for Karachi is being discouraged due to the existing system and KESC would itself be discouraged to make the requisite investments,if tariff issues remain fluid as these are at the moment.Lenders would also be hesitant as well.

And finally contemplating over these problems,one reaches a conclusion that after all,the idea of privatizing distribution utilities may not be a good one.Government would have to be around to take responsibility and to keep footing the bill,if there are losses,be it private or public sector.However,IPPs have been a successful innovation that must continue and in all probabilities would be sustaining into the long term future.