A Special Research Report and
Economic Analysis of the IPP Tariff
By Dr. Anjum Siddiqui
Sep 20 - 27, 1999
Pakistans growth is dependent on direct foreign investment and
one of the major hindrances to increased foreign investment has been the yet unresolved
issue between the Independent Power Producers or IPPs and WAPDA.
There has been a lot of controversies in the media regarding the actual
details of the contracts that were signed as well as studies of the actual long term
benefits of using IPPs.
The fact of the matter is that the IPP issue has to be resolved and the
quicker it is, the better for the country. To play our part in assisting and helping to
clarify some of the confusions that have resulted in this sector of our economy, PAGE
is creating an open forum and is inviting letters and articles from our readers whose
input would help.
We have asked Dr. Anjum Siddiqui of HUBCO to open this forum with his
views and he has presented us with a paper which we have decided to use as a cover story.
I would like to express that the views stated in Dr. Siddiquis article are not
necessarily shared by PAGE. We would like to think of them as an invitation to
response from anyone involved in this industry.
High electricity bills have become a national issue and seriously
eroded the competitive performance of our industry and agriculture. Foreign investment has
all but dried up, investor confidence is at an all time low and the country is bleeding
through a prolonged recession which shows no signs of ending. Even after deliberations of
12 IPP committees, the IPP crisis continues unabated and there is no immediate solution in
The GoP contends that the IPPs are solely responsible for high
electricity bills. The tariff row started in early 1998 when the present government of Mr.
Nawaz Sharif decided that the Agreements signed under the Benazir Bhutto government were
invalid, fraudulent and could not be afforded by WAPDA. Since then WAPDA, assisted by
Ehtasab Bureau are on a witch hunt to prove that (a) IPPs including Hubco were involved in
corruption and (b) IPPs including Hubco produce expensive power more expensive than
the state utility WAPDA.
The misperception that the IPPs are solely responsible for high
electricity prices is based on the belief that IPPs hoodwinked WAPDA into signing
expensive power purchase contracts with them. Such rhetoric draws attention and blame away
from the parties who are actually responsible for high electricity prices in this country
i.e. GoP and WAPDA. In the case of GoP, regressive taxes such as Petroleum tax, Octroi and
Excise Duties etc. have significantly increased the price of fuel and overall cost of
production of electricity. WAPDAs production inefficiencies, distribution losses and
overemployment have increased its costs of production and distribution, which it seeks to
recoup through exorbitant surcharges. No wonder that the price of electricity has shot up
for both industry and households.
It seems that the media and industry experts in our country have turned
a blind eye to the contribution of GoP and WAPDA in high electricity prices. Instead the
focus is on the much maligned IPPs against whom a number of "reasons" are being
advanced as explanations of high tariffs.
"Causes" of High Tariffs: It is alleged that tariffs charged
by IPPs are high because:
(i) IPP tariffs are front loaded - i.e. higher in the initial years and
lower in the latter years
(ii) IPPs 18% real dollar rate of return is "excessive"
(iii) WAPDA has to pay a minimum 60% capacity charge even if it
purchases less power
(iv) IPPs Fixed Costs are higher than WAPDAs Fixed Costs
(v) WAPDA has to pay foreign exchange risk insurance (in the case of
In other words it is being argued that the IPP contracts should have
been structured differently. None of these so called "causes" actually supports
the flawed proposition that IPP tariffs are high.
Essential Elements of an IPP Contract: Looking purely at the project
economics, and all the risks that are associated with greenfield (new) projects, and given
the fact that Pakistan was facing immense difficulties in raising international capital
through bonds or loans, one cannot but help conclude that irrespective of whether there
was the alleged "over-invoicing" in capital costs and irrespective of the silly
assertion that "WAPDA did not know what it was signing" and they were duped into
signing "expensive contracts", the IPP contracts that have been signed are
optimal. Any investor would have demanded some fundamental clauses in the IPP contracts,
without which no investment would have taken place.
These are an 18-20% return on investment commensurate with the risk of
the project in a low investment-grade country, a fixed capacity charge for captive IPP
capacity purchased by WAPDA, provision of tariff escalation in the presence of inflation
and rupee depreciation, economically viable compensation to the Operations and Maintenance
Contractor for running the plant, some type of foreign exchange risk insurance unless
WAPDA wishes to self insure, guarantees provided to lenders and investors by GoP about
sovereign risk and fulfillment of obligations of key parties i.e. WAPDA (procurer of
electricity), PSO (fuel supplier), State Bank (Foreign Exchange provider). These essential
ingredients of the Power Purchase Agreement would remain the same even if WAPDA signed new
contracts today. In fact, given the further deterioration in the economic environment, new
IPPs would be extremely reluctant to sign contracts and if they do, they would demand even
higher risk premiums than those agreed for current IPP contracts.
Front Loaded Tariffs: It has been argued that WAPDA should have
negotiated a differently structured tariff as the tariff profile shows that tariff is
front loaded. The tariff profile of a project is determined by the amount of debt and by
the structure of financing arrangements with lenders. As such it makes no difference
whether Hubco, or another IPP or WAPDA are the loan recipients the tariff profile
would be the same for all. The average Base Tariff (or Reference Tariff) in the case of
Hubco is Rs. 2.21/kWh (during year 1-5), Rs. 1.49/kWh (during year 6-15) and would fall to
Rs. 1.19/kWh during the years 16-27 of project life (the last year being 2027). Upon
payment of senior debt, after first 8 years in the year 2005, Hubcos Base Tariff
would fall by 15% and upon payment of subordinated debt in the year 2015, the tariff would
fall by an additional 5%. There onwards the tariff would be just sufficient to cover the
remaining dividend payments and other Fixed Costs.
The above statistics reveal that IPPs tariffs are indeed front
loaded because IPPs have to make huge payments for debt in the initial 8-15 years of
project life. Top that off with a constantly depreciating rupee and the international debt
payments become much larger, making the front loading appear more pronounced. The bottom
line of the above arguments is that front loading was necessary and that WAPDA or anyone
else could not have negotiated any better.
"Excessive" Return on Investment: There is also the
charge that if IPPs had not got away with an 18% return, the tariffs could
have been lower. Pakistan was, and still remains, a high risk country for investment
purposes. Wars, nationalizations, prolonged military rule, civilian unrest, poor economic
growth and very low foreign exchange reserves had made the investors reluctant to take
exposure on Pakistans sovereign and project risks. The providers of capital demanded
an adequate risk premium and an 18% dollar rate of return was the minimum return which
could interest investors. The IPPs are paying the price today for taking on this risk,
such as WAPDAs inability to honour its signed contracts and the GoPs
reluctance to fund its sovereign guarantees for default of WAPDAs contractual
obligations towards IPPs. If the GoP guarantee is worthless, then what recourse do project
equity sponsors and lenders have for compensation of political risks?
Minimum Capacity Charge: Another common charge against the IPPs is that
electricity is expensive because WAPDA has to pay the IPPs a fixed monthly capacity
utilization charge (at 60% of installed capacity) even if it is utilizes lesser or even
zero capacity. WAPDAs Capacity Payments to Hubco alone were supposed to be
approximately Rs. 1 billion per month (it pays much less 730 million). Such
capacity charges make economic sense and are entirely justified. If WAPDA is not going to
allow the IPPs to sell power in the open market, then surely it must pay for the captive
capacity that was installed at the cost of millions of dollars. One cannot have captive
power and not pay for it. It is like booking a hotel room and not paying for it. Where
would the hotel owner recover his lost revenues from, especially if he is not allowed to
rent rooms to anyone else who is willing to pay.
WAPDA can reduce its per unit capacity payments and hence the per unit
tariff payments to Hubco, if it purchases more hours of electricity. How? If WAPDA were to
purchase more hours, its Total Fixed Cost would remain constant (in rupee terms), but its
per kilowatt Fixed Costs would fall, thereby resulting in lower prices of electricity.
This is so because the Fixed Costs are now spread over more units of purchased power.
In fact, WAPDA has not been buying enough power to reduce its average
costs. In 1997-98, WAPDA utilized only 55% of the available plant capacity of Hubco, 42%
of Kohinoor Electric and 45% of Kot Addu Power Company (KAPCO). Thus, approximately 50% of
the capacity of these plants went to waste through non-utilization by WAPDA. The
unutilized capacity could not be diverted for sale to other potential buyers, as under the
PPA, IPPs are bound to sell to WAPDA only. The upshot of the argument is that if WAPDA had
purchased more capacity say 85% (of Hubcos capacity), it would have been able to
reduce its per unit tariff actually paid to Hubco by 20%. WAPDA could have purchased more
power saved on its per kilowatt capacity charges and passed on these savings to the
consumer. Instead, it kept imposing exorbitant surcharges and electricity bills have
become expensive by the day. If WAPDA purchases more power, the above fall in tariffs
would be achieved even if all other costs remain the same i.e. the government does not
remove or reduce the petroleum surcharge, inflation does not come down and the current
rate of rupee depreciation persists.
IPPs High Fixed Costs: WAPDA has reluctantly accepted that
IPPs variable costs are cheaper than WAPDA due to their fuel efficiency but they
insist that the Fixed Costs of IPPs which are approximately 60% of the total costs are
much higher than WAPDA.
Let us analyze the non-fuel fixed costs and consider the veracity of
these claims. These costs pertain to Debt Servicing, Fixed Operations & Maintenance
expenses, Companys Administrative Overheads, Insurance Costs and Return to Equity
Debt Costs: Debt servicing is a major component of fixed costs.
The project was financed with a 75:25 debt-equity ratio and debt servicing amounts to 28%
of the per unit (kWh) tariff of Hubco. Unfortunately, debt servicing costs cannot be
directly compared between WAPDA & IPPs for a compelling reason. WAPDAs older
plants were set up with highly subsidized financing from international donor agencies such
as World Bank and Asian Development Bank and such subsidized financing is no longer
available to WAPDA. IPP plants on the other hand have been financed at internationally
competitive interest rates. Therefore, comparing IPP debt costs with WAPDAs is a
futile exercise simply because the cost of loans has escalated in the post cold war
What would be WAPDAs cost of financing today if it embarked on a
new project? To qualify for any World Bank/Asian Development Bank assistance WAPDA would
have to first raise on its own 40% of the capital cost of the project. Such costs would
most certainly be more than IPPs, as lending banks would demand a hefty premium keeping in
view WAPDAs financially unsound balance sheet and its poor track record of honouring
its contractual payments to IPPs. To Hubco alone, WAPDA owes Rs. 9.3 billion in arrears
for the capacity charges. One wonders which banks (if any) would give WAPDA better loan
terms than IPPs who have been able to set up their multi million dollar projects at very
competitive interest rates. WAPDAs inability to raise finances through the failed
WAPDA Bond Scheme is still fresh in the minds of many Pakistanis.
Operations & Maintenance Costs: WAPDA has made a huge fuss
over Hubcos Operations & Maintenance (O&M) costs and alleges that O&M
costs are very high. O&M costs constitute only 4.3 % of Hubcos Total Costs and a
mountain has been made of a molehill. On a comparable basis, WAPDAs O&M costs
may be cheaper than IPPs, simply because WAPDAs maintenance record leaves much to be
desired. Engineers estimate that due to poor maintenance and operations practices,
WAPDAs available generation capability has been reduced 20% below their installed
plant capacities resulting in a capacity loss of approximately 1500 MW. So, while
WAPDAs Operations and Maintenance costs are perhaps lower than IPPs, this cost
saving has been achieved through permanently lost generation capability
resulting in an approximate loss of Rs. 80 billion to the country.
Administrative Costs: WAPDAs administrative overheads are
surely much higher than IPP overheads. This becomes evident when we compare the relative
employment of WAPDA & Hubco. Hubco and its plant operator employ 350 people to
generate 1292 MW which means a ratio of 3.69 MW per person. WAPDA employs approximately
138,000 people to produce an installed capacity of 7795 MW (derated capacity is much
lower) and if we make the generous assumption that 20% of this workforce is associated
with power production the ratio of power produced per person still works out to be less
than 1 MW per person which is much less than Hubco.
Return to Equity Investors: This is another major fixed cost of
Hubco which is allegedly high according to WAPDA. It has been charged that Hubcos
capital investors have already taken all their money out. This is most incorrect.
Shareholders purchased Hubco shares in October 1994 at a price of Rs. 13.26 per share and
received their first dividend of Rs. 7 per share in 1998 and a second return of Rs. 3.91
in 1999 (undistributed). With these dividends the annual return on investment for
Hubcos Rs. 10 face value shares is 10.3% (in rupee terms) which translates into a
meagre return of 1.05% (in dollar terms). Contrast these earnings with the promised 18%
real dollar rate of return that shareholders were promised and WAPDAs allegations of
excessive returns falls apart.
The above clarifications demonstrate that IPPs have made a very
strong economic case about being cheaper than WAPDA in fixed costs.
Role of GoP & WAPDA: IPPs only produce electricity, they do not
distribute it (WAPDA does) and neither do they determine the cost of their raw materials
(the GoP does). Surely these two parties play a big role in determining the price of
electricity in the country. The GoP affects the price of electricity through affecting
furnace oil prices, inflation and exchange rates and taxes/octroi. WAPDA affects the price
of electricity through surcharges levied in electricity bills and through inefficiency in
distribution and general management.
It is correct that electricity bills paid by the consumer have
increased significantly. Over the three year period 1996-99, the increase in Hubcos
average actual tariff over the average reference tariff has been a phenomenal 71%, almost
exclusively due to factors outside the control of the Company. The following table
illustrates the point.
Reference tariff (unindexed or Base Tariff)- (I) Rs. 2.53/kWh
Actual tariff billed to WAPDA- (II) Rs. 4.31/kWh
Tariff Escalation = (II-I) and % increase Rs. 1.78/kWh (or 71%
39% of the tariff increase is explained by fuel price hike, 25% by
rupee devaluation, 20% by the high cost of foreign exchange risk premiums charged by the
State Bank of Pakistan and which are quite high in the initial years of insurance
coverage, 7% by inflation and 8% by other factors.
Note that almost 40% of the tariff increase is due to increase in fuel
prices which have increased as the direct consequence of GoPs furnace oil
surcharges. During the 3 year period 1996-99, furnace oil prices increased by 34% from Rs.
4515 per tonne to Rs. 6070. This increase is associated with an escalation in furnace oil
surcharges from 14% to 25% of the per tonne price of furnace oil.
The governments most recent measure of increasing furnace oil
prices by another 15% would further increase electricity prices. The GoPs plea that
this increase was necessary in the face of a rise in world furnace oil prices is not
economically prudent. The prudent policy is to absorb the fluctuations in world oil prices
in domestic prices and to simultaneously reduce the furnace oil surcharge. Obviously,
government revenues would decline, but these should be made up through increasing the tax
net for direct income tax collection and not through further petroleum surcharges which
are highly inflationary in nature. The government continues to seek the easy way out to
the detriment of the whole macroeconomy.
Over and above the fuel price impact, a constantly depreciating rupee
and foreign exchange risk insurance costs account for another 45% tariff increase. Thus,
fuel price hikes, rupee depreciation plus hedging measures and inflation explain 92% of
the total increase in tariffs. These factors are totally outside the control of IPPs and
are the direct consequence of the GoPs macroeconomic policies.
It is most unfortunate that those who have jumped on the
"Bad-IPPs" bandwagon have totally lost sight of three important facts, that:
(i) the GoP is mismanaging growth policies which has created a
recession and consequently reduced electricity demand.
(ii) the GoP has failed to check the decline in the value of the rupee
which along with inflation is responsible for a 53% increase in tariffs over the last
(iii) the GoP has consistently failed over many decades to address the
single most important issue facing Pakistans economy, that is, insufficient revenue
collection from direct taxes. The failure to raise direct taxes has led the GoP to levy a
plethora of indirect taxes of which the furnace oil and petrol taxes are the worst in
terms of their inflationary consequences.
(iv) the GoPs efforts to cleanse WAPDA through the army
intervention has met with very limited success and all major ailments of WAPDAs
balance sheet remain uncured. The failure to check the rot in WAPDA has resulted in a
vicious circle of ever escalating electricity surcharges which are the direct consequence
of WAPDAs 30% line losses, 109% increase in receivables and operational and
administrative mismanagement. There is no alternative but to expeditiously privatize WAPDA
on which the GoP does not seem keen, atleast for the foreseeable future.
By critically examining all the so called "causes" of high
cost of electricity, this article establishes that it is the escalation in fuel costs due
to GoPs petroleum taxes, increase in debt costs due to depreciation and increase in
all other costs due to inflation is the reason dÍtre for higher electricity
prices in Pakistan. Top that off with WAPDAs ever increasing surcharges levied to
recoup losses from production inefficiencies and we have the reason for expensive
electricity in Pakistan. None of these factors are caused by or are under the control of
IPPs and consequently blaming them for high electricity prices is incorrect and results
only in diverting blame from the real contributory forces, namely, GoP & WAPDA.
DR. ANJUM SIDDIQUI
Financial & Risk Management
The Hub Power Company
Dr. Siddiqui is an Economist and currently working as Senior Advisor on Financial and
Risk Management with the Hub Power Company. Before joining Hubco, he was employed with
Engro Chemical Pakistan Ltd. (formerly Exxon) as Business Planning Advisor of New
Projects. At Hubco, he is an important member of the team which is responsible for
negotiating with the government and resolving the current controversies surrounding
Previously, Dr. Siddiqui was an Associate Professor at the Graduate School of Business
& Economics at the University of Auckland in New Zealand. Upon returning to Pakistan,
he has taught at the Applied Economics Research Centre (AERC) at University of Karachi and
is Visiting Professor at the Institute of Business Administration (IBA) at the University
Dr. Siddiqui specializes in Macroeconomics, International Trade & Finance and also
in Project Management and Project Financing of large multi million dollar projects. He has
published many articles in prestigious international journals of economics e.g.
International Economic Journal, New Zealand Economics Papers, Pakistan Development Review,
Indian Economic Journal etc. and in the daily newspapers "Dawn" and "The
News" as well as in Zameen magazine.
Being an active researcher, he has presented many papers on economics in conferences of
American Economic Association, Canadian Economic Association and New Zealand Economic
Association. He recently presented a paper "IPPs: The Real Issues" at the annual
conference of Pakistan Society of Development Economists in Islamabad. The paper was well
received by the economists and the general audience.
Dr. Siddiqui is also an Associate Member of the Federal Reserve Bank of San Francisco
and is on the Editorial Board of International Journal of Business Studies published from
Australia. He has appeared many times as an expert commentator and analyst on the Pakistan
television programs "Business Week", "Business Update" and the
Dr. Siddiqui has been a consultant to the Reserve Bank of New Zealand, ABN-AMRO Bank,
Leasing, Power and Gas Companies. He has also lectured senior staff of the State Bank of
Pakistan and has recently worked as a member of the Prime Minister's Committee on
"Monetary Policy and Balance of Payments" at the State Bank of Pakistan.