The burgeoning burden of capacity payments

As Pakistan prepares for a significant increase in electricity prices next year, driven by further rupee devaluation and capacity payments of over Rs 2.1 trillion, addressing these issues that have bogged down the entire economy has become a question of survival. One of the biggest contributors to prohibitive power tariffs is the heavy burden of capacity payments of over Rs 2.1 trillion per annum, which necessitates an urgent action.

Pakistan’s energy sector has long been entangled in flawed contractual arrangements with Independent Power Producers (IPPs). These contracts, dating back to the Power Policy of 1994, were intended to resolve the energy crisis by attracting private investment. However, the terms of these agreements have led to a spiralling circular debt, reaching Rs2.64 trillion as of February 2024.

The incentive structures offered to IPPs, including guarantees indexed to the US dollar, mean any depreciation of the Pakistani rupee increases returns for IPPs and places a heavier financial burden on the government. Initially, the return on equity for IPPs was set at 18%, later reduced to 12% in the Power Policy of 2002, but it remains high compared to global norms.

Additionally, cost comparisons with similar projects in other countries suggest that many IPPs were funded through over-invoicing on capital goods, resulting in no “real” underlying equity. Consequently, Pakistan is burdened with perpetual returns on ghost equity. An analysis of various published accounts and balance sheets further reveals that actual dollar-based returns to many IPPs exceed 70%.

Additionally, the government’s decision to incorporate residual fuel oil (RFO) plants, known as Peaker plants, to boost base capacity has proven problematic. These plants are inefficient, costly to operate, and environmentally unfriendly.

While the inclusion of Peaker plants is not inherently problematic, their disproportionate share in Pakistan’s energy mix, currently at 14%, is concerning. Globally, these plants typically operate during peak demand periods and constitute a maximum of 4-6% of total consumer bills.

Pakistan has an installed capacity of approximately 44,943 MW, with a huge disparity between a base-load of around 12,500 MW and summer peak load of around 30,000 MW due to shifting of winter heating loads to gas.

However, due to contractual obligations, the government must pay for the entire installed capacity year-round, regardless of utilization. In contrast, global grid planners operate some plants solely during peak demand periods, paying only when the capacity is actively utilized, while Pakistan’s generation mix is heavily skewed towards take-or-pay base-load plants.

There are two main types of energy contracts: take-or-pay and take-and-pay. Pakistan operates under a take-or-pay contract system with IPPs, where a fixed percentage of their capacity must be purchased regardless of actual demand.

This setup can be unfavorable for buyers, as they must pay for electricity up to the contracted capacity, leading to increased unit costs. In contrast, take-and-pay contracts involve buyers paying solely for their electricity consumption, though this can lead to higher prices due to negotiation or competitive buying.

The tariff structure in IPP contracts also raises issues. Consumer tariffs include various components like Energy Purchase Price (EPP), Capacity Purchase Price (CPP), T&D losses, Distribution and Supplier Margin, and prior year adjustments.

Besides IPP charges, consumer tariffs also include add-ons from Distribution Companies (Discos), such as technical losses (typically 5-10%) and factors like theft and uncollected receivables, which inflate these add-ons to over 20%.

In FY 2022, EPP comprised roughly 60% of the tariff, with CPP at 40%. By FY23, both EPP and CPP were around 50%, marking a shift from historical trends. Projections for FY24 suggest a further deviation, with CPP expected to rise to 67% and EPP decreasing to 33%. This increasing emphasis on fixed charges significantly inflates tariffs, posing challenges for consumers.

Moreover, there is significant alleged misreporting and overbilling done by IPPs as the tariffs enshrined under the take-or-pay contracts are guaranteed under international law. For instance, the actual oil consumption of several oil-based plants is allegedly less than what is billed by the IPPs; there have been alleged attempts to audit these occurrences, but any such efforts are thwarted by IPPs through, among other means, stay orders, etc.

Similarly, the O&M margins are also overstated, where the expense is Rs 500 million it is being billed at Rs 1.5 billion per annum. All other heads are similarly overstated but because the sanctity of these contracts is protected under international law and the government of Pakistan has surrendered its sovereign rights there is little that can be done to reevaluate these contracts.

Currently, electricity tariffs in Pakistan are prohibitively high. Over the past 24 years, tariffs have surged from Rs 1.37/unit in 1990 to Rs 34.31/unit in 2024, a 25-fold increase. This rise is not solely due to variables like PKR-USD parity but also due to factors like the introduction of private generation and the government’s tendency to pass on its own socio-economic obligations to certain power consumers like industrial and high-end domestic through cross-subsidies.

This scenario has contributed to premature deindustrialization, causing a decline in electricity consumption and elevated electricity costs. Immediate action is required to lower power tariffs for industries to 9 cents/kWh, stimulating demand for electricity and effectively utilizing idle capacity. Furthermore, the addition of new capacity to the system should be halted for the next 3-4 years.

Removing cross-subsidies, which act as indirect taxation on exports, is essential. Increasing tax collection to directly subsidize energy for economically disadvantaged segments and transitioning to other direct support mechanisms like unconditional cash transfers, as advised by IMF and World Bank consultants, is more economically efficient compared to cross subsidies in power tariffs.

Moreover, to reduce the undue burden of capacity payments within current contractual agreements across all consumers, there must be a significant increase in power consumption. Typically, industries drive electricity demand globally.

However, in Pakistan, inefficient allocation leads to unproductive sectors consuming a significant portion of electricity (around 47%) while industries consume only 28%. This results in industries bearing the burden of inefficiencies through cross-subsidies and additional transaction costs.

Competition plays a pivotal role in the effectiveness of take-or-pay contracts. Competitive bidding often results in favourable arrangements, especially in cases involving multiple investors and suppliers in large countries. However, problems may arise in government-to-government contracts without competitive bids, highlighting the importance of clear contract pricing through market mechanisms.

In advanced countries with competitive electricity markets, take-or-pay contracts are prevalent. Here, electricity prices are influenced by supply and demand in spot markets, offering a mix of options for both buyers and sellers to mitigate risks effectively. Even in Pakistan, the ADB-funded Jamshoro coal power plant has demonstrated cost-effectiveness through competitive bidding.

However, while these points must be kept in mind while negotiating future contracts, ultimately, the resolution to Pakistan’s existing capacity payment woes lies in stimulating industrial growth, which will significantly increase power consumption and reduce the per-unit burden across consumers.

Copyright Business Recorder, 2024