Why renegotiating the IPP contracts may cause more problems than it solves

When the government first announced that it had renegotiated contracts with independent power producers (IPPs) that it deemed excessively favourable to the power companies, it was almost uniformly hailed as a successful policy achievement. There seemed to be a general consensus that electricity generation in Pakistan was too expensive (it is), and that the supposedly excessive profits of the industry were to blame (not really).

However, in the aftermath of the initial celebration, what is now emerging more clearly than before are two key problems that have been largely ignored by the public.

The first, of course, is that the government is setting a bad precedent by effectively breaking multi decade agreements by forcing the power companies into renegotiation. Now, the government’s claims that these renegotiations were ‘voluntary’ were iffy to start with, and a government doing away with longstanding agreements simply because it finds them politically inconvenient will be damaging to the government’s credibility when it comes to contracting with private sector entities in the future. This is particularly dangerous because the country will need them when it comes to building infrastructure that is badly needed. 

The second problem that has been ignored is that the process appears to have been unfairly conducted, with some companies clearly treated worse than others. Several IPPs that fall under different categories were excluded entirely from the exercise. And several that were included in the set of IPPs that should have been negotiated were spared from signing on the dotted line. And then there were some that did sign, but miraculously found themselves not accused of ‘excess profits’.

Each of these is addressed in turn below, but before that analysis, it is pertinent to point out the full effects of the policy announced – even if fully implemented in the letter and spirit in which it was intended – will have at best a marginal impact on the total cost of power generation in Pakistan.

According to the March 2020 “Report on the Power Sector”, compiled by the government’s Committee for Power Sector Audit, Circular Debt Resolution, & Future Roadmap, reforms in the power purchase agreements similar to the ones the government has agreed to with the IPPs – if implemented across the entirety of the power generation sector (and the recent agreements cover only part of the IPP sector) – could reduce electricity costs to consumers by as much as Rs1 per kilowatt-hour (kWh), the basic unit of electricity purchase. (Editor’s Note: Some independent experts claim that a reduction of 25 paisas per kWh is a more realistic estimate of what the current exercise can achieve.)

Data from the National Electric Power Regulatory Authority (NEPRA) suggests that the average cost of electricity sold in the country was approximately Rs14.47 per kWh in fiscal year 2019, the latest year for which complete data is available. So, the best-case scenario of Rs1 per kWh reduction in the price of electricity is not entirely unsubstantial.

However, there is a problem. According to Profit’s calculations based on data provided by NEPRA, theft of electricity and defaults on electricity bills raise the costs of electricity to bill-paying customers by Rs4.52 per kWh.

It is not even close: the reason electricity in Pakistan is expensive is because Pakistanis steal electricity much more than even comparably developing countries. Until the government cracks down on theft, trying to fix load shedding will be like trying to heal a sword wound with a Band-Aid: it might cover a very small part of the wound, but unless you use something more suited to the task, the patient is likely to bleed to death.

Now let us dive into why the renegotiations were a bad idea in the first place.

The problem of bad precedents

The biggest problem with forcing the power companies to renegotiate their contracts is the precedent they set. To understand the impact of why these renegotiations will be bad for the economy, let us first recall why the government even conducted the first negotiations to begin with.

In the late 1980s and early 1990s, it was becoming increasingly evident that Pakistan’s electricity generating capacity, which depended largely on Tarbela and Mangla dams, was going to be insufficient going forward. Hydroelectric dams are big, expensive projects that cost billions of dollars and the government of Pakistan did not have the appetite for such endeavours. As a result, the government decided to pursue independent power producers. These were private sector power companies who would set up power generation plants and sell electricity to the state-owned electricity distribution companies controlled by the Water and Power Development Authority (WAPDA).

Now, even a power plant is an expensive endeavour, particularly for private sector investors, and they typically can only produce reasonable rates of electricity if they can get long-term financing so that they have several years to pay back the loans in smaller installments. This is a risky business as is, but there was an even riskier element, the companies had WAPDA as their only buyer. So if WAPDA refused to buy the electricity, the investor who set up the power plant would lose their investment. In addition, at least in the early 1990s, it was not clear that the private sector in Pakistan had the capacity to set up power plants, and so the incentives had to be structured in such a way that investors from around the world would feel comfortable setting up power plants in the country.

So the agreements that were structured had four big components. Firstly, they were long-term contracts that lasted for 25 years, which is the typical lifespan of a power plant, to ensure that the investor could expect a full recuperation of their investment.

Secondly, the government guaranteed that it would either buy the electricity generated by the power plant, or it would pay for the capacity to have that electricity be available to the grid if necessary. This condition was subject to the power plants ensuring that the plants would verifiably be available when the government-owned electricity distribution companies needed them.

Thirdly, the contracts set a guaranteed rate of return built into the contracts so that there would not have to be constant renegotiations and disputes over what price the IPP could charge. The government would get a predictable price, and the IPP would get a predictable profit margin.

And lastly, the profit margins were set in US dollars so that both local and foreign investors would find the returns attractive enough to make the investment. This last commitment ended up proving to be quite crucial as the first company to set up was Hub Power Company, which was set up by European energy companies.

None of the reasons why any of these four conditions were put into the contracts have materially changed. Power plants are still long-term investments. The government is still effectively the only buyer. Predictable prices are still preferable to constantly renegotiated ones. And Pakistan still needs to attract foreign investment into its energy infrastructure.

So if the conditions that made the contracts necessary remain the same, is there any reasonable explanation for why a renegotiation was necessary? 

Even if one or more of the conditions had changed, the agreements should still not be renegotiated. Entering into a long-term agreement with the government is an endeavour fraught with political risk. Long term agreements, however, are the only way the government can attract private investors to help fund the building of the country’s essential infrastructure, whether it be energy or any other critical infrastructure in which the private sector can help.

If the government sets the precedent that a change in administration can result in a change in essential contract terms for a contract that is supposed to last 25 years, then who will take the plunge to make an investment in Pakistan infrastructure? If the government ever calls upon private investors to help it finance future projects, who will take the government’s promises of a return on investment seriously?

The government will scare away all legitimate, long-term investors and attract only short-term sharks out to make a quick buck and then get away with whatever they can make.

Was there something so egregious in the contracts that absolutely needed to be changed? Not in the ones negotiated in the 1994 or 2002 IPP policies, which set off two waves of power plant construction in Pakistan (the 2015 policy was another matter entirely; more on that below).

But even if there was something clearly wrong with the contracts, the best way to correct for a badly negotiated contract by a previous administration is to set a new precedent by negotiating better ones with new investors, or even some of the older ones, but for new projects. Bad precedents do not get erased by creating more bad precedents. They go away if they are followed by good precedents, by governments learning from the mistakes of their predecessors and moving forward, rather than relitigating the past.

Even if the government felt there was possible corruption in the negotiation of the previous contracts, it should gather evidence and submit it in court (not, for the love of all that is holy, through the National Accountability Bureau, which is more of a witch hunt). If litigation is necessary, it should be pursued through the judicial route, not through forced renegotiations.

Why negotiate with some IPPs and leave others out?

The above argument relies on understanding the value of long-term thinking, which is not always easy to grasp. But there is another reason to oppose the government’s renegotiation efforts, which is that it is very clear that some power companies were clearly left off the list of contracts that the government report pointed out as having generated ‘excess’ profits, while others were forced to renegotiate their contracts.

Within this, there are two problems. The first is that the government did not uniformly apply its decision to force renegotiated memoranda of understanding (MOUs) on the power plants that were set up during the 1994 and 2002 IPP policies. Some plants set up under those policies were clearly left off the list.

For example, the Uch Power plants were both set up under the 2002 policy whereby the government had initially guaranteed a 15% return on equity in US dollars. Under the renegotiated terms, plants owned by local investors would see that rate revised to 17% in Pakistani rupees, while those owned by foreign investors would be forced to cut that 15% US-dollar-linked rate down to 12% in US dollars.

Uch Power is owned by Engie, the French multinational electric utility company formerly known as GDF Suez. If the government had been uniform in its application of that policy, Uch Power would have been made to sign an MOU that agreed to take their return on equity down to 12%. But a prominent member of the government’s Committee who did not want to be named confirmed to Profit, that Uch and a few others have not signed any such MOUs. “Negotiations with a few IPPs were taking longer, and we had to finish the task. We decided not to delay the process by another month, so we asked the government to decide with these 3-4 IPPs directly. But yes it’s true that as of today, these remain unsigned,” they said. 

That selective application of the policy is in itself a problem. And it is affecting the government in more ways than one. For instance, the government had planned the privatisation of the state-owned Havelli Bahadur Shah and Balloki power plants. Both plants run on liquefied natural gas (LNG) and both were set up under the 2002 policy. Yet the government has had to delay the privatisation transactions because investors are skittish about buying power plants if they do not have certainty on what rates of return they can expect.

But the most egregious application of selective renegotiations is the fact that all IPPs set up under the 2015 IPP policy – which allowed for the setting up of coal-fired power plants as part of the broader China-Pakistan Economic Corridor (CPEC) set of projects – have been thus far exempted from renegotiation, even those contracts include some truly outrageous terms.

Those power plants have been extremely expensive to set up because the Chinese companies selling the coal-fired power plants have been price gouging Pakistani companies. Nobody else in the world makes coal-fired power plants anymore, so Pakistani companies have no choice but to buy Chinese equipment.

To put the costs into perspective, the average cost of these Chinese-made coal-fired power plants has been $1.55 million per megawatt (MW) of installed power generation capacity. This compares highly unfavourably to the plants set up using American or European equipment, which tends to last longer than Chinese equipment, and came in at a cost of between $0.9 million to $1.1 million per MW of installed capacity.

On top of these higher costs – which will have to be paid for by Pakistani consumers through higher tariffs – is the fact that these coal-fired power plants have been promised a return on equity of 30% in US dollars.

Yes, you read that correctly, the dirtiest, most expensive power plants, with questionable equipment quality, are going to cost the most to Pakistani consumers, and have been promised the highest rates of return.

On top of that, they were sold to the Pakistani public with a lie. We were told that these plants would use indigenous coal from the Thar coalfields. But the vast majority of these projects are using imported coal, and only Engro’s project uses indigenous coal.

If ever there was an egregious policy that deserved attention for renegotiation, it was the 2015 policy, and yet, miraculously, it was left off the government’s list of power plants to force into renegotiation. What possible justification could there be to renegotiate contracts with companies that were promised literally half the rate of return of these plants, and yet leave these contracts untouched? 

To many, CPEC and Chinese connection seems to be a plausible answer. But funnily enough, out of the seven coal-fired power plants set up under the 2015 policy, two (Lucky and Jamshoro) are not part of CPEC but even they seem to have been spared. And at least two more coal-fired power plants, namely Thar Energy and Thal Nova, even though technically listed under CPEC projects, are essentially owned by local companies with minority stakes of Chinese companies. 

Excess Profits: a damp squib?

The government’s committee had recommended the recovery of Rs 100 billion of excess profits from IPPs, but according to sources familiar with the matter, the number could not stand the test of reconciliation and after adjusting for some basic accounting errors, the amount has since reduced significantly. 

What is worse, is that even here there seem to be double standards at play.  Take for example the two very similar oil based plants, Atlas Power and Nishat Power, both set up under the 2002 Power Policy, Both have similar tariff and Project costs per Mega Watt and have the same Heat Rate, efficiency, O&M costs, and rate of return. But despite this the excess profits computed for Nishat plant are double than those for Atlas. 

In the case of HUBCO Narowal, another plant with similar credentials, the excess profits were not calculated to begin with.

The government’s committee member has an explanation, “Two plants of HUBCO are parked under the same company and it was taking time to separate the financials of the two plants to ascertain the excess profits of each plant, hence it was not included in the report. Later on this figure was submitted to the government in a follow up report,” (Editor’s note: Profit tried to independently verify the existence of this secondary report but could not get any confirmation). 

And then there is this tiny issue of leaking the damaging parts of the report (some of which were later revised due to inaccuracies) to the media even before the Ministry of Energy, Power Division could lay its hands on it.

What can we expect now?

The whole process seems very badly managed, and according to sources familiar with the matter, may not even yield any savings to the state-owned electricity distribution companies at all. All of these MOUs are effectively non-binding statements that have yet to be translated into actual contract language and signed by each party.

Unless that happens, this whole exercise will not have meant much at all, which will result in the worst of all possible outcomes: all the bad publicity and breach of trust of renegotiation, without any of the actual savings.

In short, the renegotiations may sound like they were a good way to save money, but the reality is that the Pakistani energy grid is inefficient because of theft, not excess profits of power companies. Forcing these companies to renegotiate sets a bad precedent that will destroy the government’s credibility in future negotiations with any private sector investor who may have otherwise been willing to invest in helping build the country’s infrastructure. And the whole exercise appears to have been conducted with a selectivity that renders it vulnerable to accusations of favouritism and corruption.

And even after all of this, it may still not achieve even its stated objectives. With all that going against it, it is an indictment of the shallowness of the national debate that the policy got as much positive coverage as it did. It most certainly did not deserve it.

Additional reporting by Ahmed Ahmedani