Power sector controversy: take-or-pay contracts

Energy prices have increased tremendously which has created controversy and unrest in the country. IPP contracts are under great debate. Many people argue that these are unfair and unjust.

Take-or-pay contracts are criticised arguing that IPPs are paid even if no electricity is produced and supplied. Capacity charges (in ordinary language) fixed charges are too high being two third of the total and fuel cost being one-third.

It used to be opposite earlier. Some people have even proposed nationalization of the total electrical system. Discos are already in public sector. Nationalisation would mean nationalisation of the IPPs.

Some ex-Wapda experts yearn the Wapda days and criticise the whole idea of power sector restructuring and break-up of Wapda. We will examine in this space as to the validity of these arguments and proposals and investigate if some relief is possible to the consumers.

Apart from IPP charges in the consumer tariff, there are a number of add-ons in the IPP selling price. Bulks of these add-ons are from DISCOs. There are, what people consider unreasonable add-ons from Discos; apart from technical losses which may be reasonably added at 5-10%, there is theft and uncollected receivables which bring these add-ons to more than 20%.

Some Discos have rather excessive and unacceptable add-ons such as Pesco, Hesco and Sepco exceeding 30%. Some DISCOs have quite low add-ons under or around 10%, which may however be reduced also under better circumstances and controls.

There are two types of energy contracts with some variations; take-or-pay and take-and-pay. We have take-or-pay contract system with IPPs. Under these contracts, a fixed percentage of the IPP capacity is to be bought by the power purchaser mandatorily.

Generally, 80-85% of the capacity is specified in case of thermal power plants. If IPP does not and cannot supply this much, it has to pay a penalty, although there are force-majeure conditions which protect both the sides under extraordinary conditions.

An unwanted situation under take-or-pay contact system, from the point of view of the buyer or consumer, is that it has to pay even if it does not need the electricity and does not buy it as per contracted capacity.

This results in an increase in the unit cost or selling tariff of electricity. It has to be clarified that only fixed cost are to be paid by the buyer in case of not buying. Fuel and other variable cost are not paid in case of non-supply. Thus part of the cost is paid not all. However, because capacity cost is too high (for the reasons that will be discussed in the following), it is being questioned and criticised.

Under take-and-pay contracts, buyer pays for only what he buys and consumes. Apparently, it may be seen as an ideal condition for the buyer; one pays for as much as he needs and consumes. But it may not be so, as they say, nothing is free.

Under take-and-pay contracts, prices are higher whether it is a negotiated or competitive buying. The risks are higher for the sellers and he builds that into the contract. Also, he assumes a minimum assured capacity factor below which the demand may not go down. In advanced countries, there are spot markets where many buyers are available and thus sellers risk are much lesser than in developing countries where electricity markets are not there.

Thus it can be concluded that take-or-pay has balanced risks for the two parties and may come out with cheaper cost than the Take and Pay costs. Especially, in developing countries under single buyer model, the risk taking capacity of buyer is more and is priced lesser than individual developer or contractor.

The issue, however, is of competition. If competitive bidding is held for awarding take or-pay contracts, it can be a good acceptable arrangement. However, under G-to-G contracts, wherein competitive bids are not invited, it can be problematic.

Under arrangement with large countries having multiple investors and suppliers, it is possible to have competitive bidding from donor or investor country. In the case of no bidding, the buyer has to have a good idea of the contract price, either through involving external consultants or if similar projects have been built recently to give a good idea of cost and prices.

This has not happened in many cases. Nepra which has responsibility in this case indulges in simplistic exercises and public hearings of questionable value. Nor is there any evidence of competitive bidding in many cases or involvement of a neutral external consultant. Most upfront tariff awarded by Nepra suffer from inadequacies and proper due diligence.

However, in cases where competitive bidding has taken place, better results and reduced prices did emerge. A classical example is of ADB-funded Jamshoro coal power plant which emerged as the cheapest power plant.

It was an integrated 2x600MW power plant which was reduced to single phase 1x600MW power plant. The issue is still alive and KE has shown interest in Part–II.

The second example is of RLNG power plants wherein competitive bids resulted in low prices. The third example is one of 600MW Muzaffargarh Solar Power plant which bidding failed to attract any party. However, current financial problems in Pakistan may have been responsible for the failure.

New bids have been invited with more attractive and less restrictive ToR. Thus it can be concluded that provided due diligence and competitive bidding takes place, Take or Pay is a good contracting approach.

Take-and-pay contracts are popular in advanced countries where there are competitive electricity markets wherein electricity price is determined in the spot markets. Contracts are made based on spot prices and associated kerb buying. Demand and supply determines prices. Both buyers and sellers have options of various kind; a mix of various modes to minimise risks.

Current price hike has two major reasons, although there may be some contribution of some undesirable practices in it; 1. heavy Rupee–dollar exchange rate devaluation from Rs 105-140 to Rs 300; doubling of international borrowing rates from 4-5% to 9-10% . LIBOR used to be 0.5% which is now 4.5-5%. As per Nepra-spread formula of x+4.5%, effective borrowing rate almost doubled from 5% to 9.5-10%. This has doubled and tripled the capacity charges and the circular debt, although subsidised tariff for the poor also has contributed.

It should be noted that IPP investor has only 25-30% share in investment and the bulk 70-75% is borrowed from the international banks. Neither IPP nor the buyer has any control on them. They work according to their own system, although reputable IPP borrowers, investing in credible buyers’ projects, manage to get better deals which may only have marginal differences from standard market rates.

It has often been argued that Nepra did award higher risk margins which could have been lower and perhaps can be still brought down if there is readiness on both the sides to negotiate. There is other criticism of front-loading of the tariff.

Under a possible renegotiation, front loading can be straightened and extended to a longer repayment period. The total effect of such adjustments may go down to 20%. There are example of ADB-funded Jamshoro coal project and recent nuclear power project in this respect. Readers are referred to our earlier writings on the subject (How to reduce electricity tariff) for details.

There may be a scope, under mutual negotiations, to introduce in existing take-and-pay contracts, some share of Take-and-pay conditions, say, up to 10-20%. This may enable the operation of a competitive market in the form of CTBCM or a more viable framework in the form of a spot market exchange. Some incentives may be given in the form of extension of PPA periods and others.

Concluding, we are a small party in the world system. World Bank, OECD and international banks determine and shape investment conditions and promote what they think are the most efficient systems, although IMF can be avoided by keeping one’s house in order. Even China and Russia follow these.

What has happened in Pakistan in terms of power sector reforms is not unique in Pakistan. It has happened in most developing countries. Neither do we have professional capabilities to conceive altogether different systems.

The proposals of reversion to Wapda monolith or nationalisation are too unserious. The contrary is being demanded by a vast majority; more privatization, especially, of Discos and provincialisation of the power sector.

The solution lies in improving the economy; balancing the external and internal account; creating employment and increasing personal incomes of the citizenry. In case of energy, most prices are determined by international market conditions.

Prices cannot be brought down, while incomes can by improving the economy. Also for generating resources for subsidising energy in the meantime, tax collection has to be increased. Sole reliance on cross-subsidies may not be feasible for long. It has already affected the industrial tariff and is affecting exports performance.

Copyright Business Recorder, 2023