200 MW coal fired plant at Naga
A 200 MW coal fired plant at Naga in the Philippines
Source: Sarah Fairhurst

In line with their swift economic development, emerging Asian nations such as the Philippines are building structures and markets that could make the traditional independent power project (IPP) obsolete, argues Sarah Fairhurst of the Lantau Group in Hong Kong.

In Asia, the classic IPP structure could be due for re-appraisal. Do the factors that brought it to the region still apply?

BP World Energy Statistics 2012
Annual average growth rate for selected Asian nations
Source: BP World Energy Statistics 2012

At the start of the independent power phase, most markets had a single monopoly utility. This would supply all power through its own generation assets and own network of transmission and distribution lines to captive customers without an alternative supplier. In more developed countries, the system would also feature well-structured regulation. In others, regulation was absent, ad hoc, or – worse yet – subject to the whims of government.

For power generators, the clear risks included:

  • Reliance on a single off-taker with no alternative source of revenue;
  • High capital costs for projects that might be prevented from operating;
  • A long economic life for projects;
  • Significant risks during construction (although fewer technical risks after commissioning);
  • Policy changes, due to electricity’s tendency to become a political minefield;
  • Uncertainty over fuel delivery and price.

To manage these risks, the IPP structure developed with several key elements. Power purchase agreements (PPAs), for instance, tackled the lack of alternative buyers for electricity and passed fuel risk to the off-taker either as a tolling contract (energy conversion agreement) or through complex pass-through pricing provisions.

Government guarantees reduced the risk that utilities would fail to pay, or that a government or regulator would bow to political pressure and cut the tariff, making a project uneconomic. International lenders countered a frequent lack of local banks able to finance something as large as a power station. International legal advisors documented the transaction to the satisfaction of international equity and debt. In sum, IPPs brought technical and commercial expertise along with funding and financing. Plants were generally built on time and to a high quality – although often at a high price.

Asia’s new context

Today, though, is this structure still relevant? And, perhaps even more significantly, is there still a role for ‘international’ power producers?

These questions can be answered through either a ‘bottom up’ approach, in which we ask whether underlying drivers have changed so much that structures must too, or from a ‘top down’ perspective, in which we see what is driving the many structures emerging in the wake of Asia’s electricity market reforms.

An analysis of what prompted the PPAs of the late eighties and the nineties highlights how the environment has changed. Back then, demand was surging across many fast-growing Asian countries while local utilities lacked the capital or staff to keep pace. Meanwhile, reforms in the UK and the USA had left utilities cash rich. Low growth limited their opportunities in domestic markets so offshore seemed the way to invest and grow. Overall, need and opportunity converged perfectly.

Electricity Regulatory Authority of Vietnam
Current status of electricity markets in Asia
Source: Electricity Regulatory Authority of Vietnam

And now? Growth has slackened in some countries where IPPs took off in the eighties and nineties such as Thailand and Indonesia, reducing the pressure for new investment. At the same time, issues in home markets and problems with overseas projects have shown ‘internationals’ that going offshore is not always the panacea it once appeared. Companies are less keen on risk and more focussed on the problems in their home markets than expanding. Many foreign firms have left Asia entirely, sometimes to be replaced by locals and pan-Asian companies.

Electricity markets – already in place in Australia, New Zealand, the Philippines, Singapore and South Korea – are now also being planned in Malaysia and Vietnam. All generators in these jurisdictions can expect a clear route to market. Volume and price may be uncertain, but most players can estimate roughly how much power they can dispatch and at what price. And, in a politically charged industry, this can be a better backstop than a government guarantee.

In these liberalised jurisdictions, many different contractual forms are also emerging to supplement the market, such as forward markets and exchanges in Australia or bilateral contracts in the Philippines. Rather than a single PPA off-taker, each generator may now have several, often smaller, counterparties plus some exposure to the spot market – which spreads credit risk and recontracts risk.

That said, selling in a merchant environment involves more effort. The competition is every day with dispatch into the market or every year for recontracting smaller off-takers, while competition is ‘once and for all’ at the original PPA tender/negotiation under the PPA approach. Another change is that far fewer Asian countries offer guarantees. The Asian financial crisis in the late nineties alerted governments to the downside. Falling currencies forced up tariffs, which often had significant dollar denominations. Some nations, such as Malaysia, rode out the storm and countries such as the Philippines achieved some minor renegotiations. But others, including Indonesia, cancelled entire projects, some of them supposedly closed.

Without government guarantees, the structures that relied on them are threatened. How else can projects ensure off-takers pay on time, particularly if uncertain times bring falling currencies and/or rising fuel prices?

In the eighties and nineties, outside Malaysia, few local banks participated in funding IPP projects. The big funders were international banks, such as those based in the US, Europe and Japan. Local banks are now far more prominent and well capitalised. Local debt is now significant in India, China and the Philippines and is growing in the other Asian markets, ending the era of exclusively foreign and mandated lead arranger (MLA)/export credit agency (ECA) support.

As international lenders exit the picture, so do international advisors. In each Asian nation, entire industries are now emerging, along with local advisors and lawyers. This is driving an increasing diversity in documentation and structuring. A single ‘standard’ structure has been superseded by myriad alternatives.

The Philippines: perfect case study

So does a PPA or the market provide a better return? In many locations this is a tricky question: not everywhere with a market can also offer PPAs. But in the Philippines, which offers both, purchasers can get power more cheaply – though with some volatility – from the market. In competitive markets, then, developers get higher returns with PPAs.

World Bank
Proportion of local financing in Asian IPPs (2005)
Source: World Bank

This point is illustrated by a ‘bottom up’ look at the Philippines’ different environments: its Wholesale Electricity Spot Market (WESM) operates in Luzon and Visayas, while neither a market nor even balancing arrangements exist in Mindanao.

In Luzon and Mindanao, the market can offer IPPs new ways to sell power: either directly into the spot market or via contracts with retailers, including distribution utilities such as Meralco or electricity co-operatives. For now, generators still cannot sell directly to customers, as WESM – the only market – has yet to implement open access (which could bring its own problems by unsettling retailers and deterring them from committing to the longer-term deals that underpin financing).

World Bank
Recent IPP financing sources
Source: World Bank

Unlike in the heyday for IPPs, generators face the risk that regulators may unilaterally attempt to change IPP project tariffs by preventing retailers from passing costs on to customers. Even when power has been competitively sourced, the Energy Regulatory Commission (ERC) has an unfortunate history of this. But equity and debt is available. Local lenders are much more prevalent in IPP transactions and local electricity companies are now dominate asset ownership. Since the Philippine Electric Power Industry Reform Act (EPIRA), power stations are no longer either owned or contracted to the NPC.

Local operators have learnt from international players and have reasonable technical competence. Kit still comes from abroad, so currency risk remains, but Chinese and Korean equipment has largely replaced American and European machinery, easing US dollar issues. But not all aspects of the new, locally owned and locally financed market are ideal. While much capacity derives from domestic gas, hydro or geothermal resources, most coal fired power stations still depend on imported fuel, so face both price and currency fluctuations. As prices on both the spot and contract markets are typically in pesos, generators must manage this risk. If LNG is imported as planned, this will present even greater forex risks.

The Philippines’ struggle for capacity

In Visayas, where the market only recently arrived, new plants are now appearing, underpinned by contracts with local retail companies such as distribution boards and electricity co-operatives.

In Luzon, where the market is best developed and the players are most robust, some new plants have already been set up. One example is GN Power, a project based on Chinese equipment, underpinned by many small contracts with local utilities, and financed by US, China and local sources.

But new structures have left gaps in the market. While more projects are being mooted in Luzon, the rise in capacity here has slowed since the market arrived. Overcapacity is partly to blame, but the new arrangements have yet to be tested amid tight supply-demand.

Further south, Mindanao combines a lack of access to the WESM with a pressing need for new power. Frequent brownouts hit hard when dry years affect local hydro stations. This region still resembles the environments where the IPP rush peaked in the eighties and nineties, with growing demand and difficult operating conditions.

So is Mindanao the perfect location for an IPP? A process has recently been run here to tender for a new power station, with 21 regional electricity co-operatives (ECs) working together to attract international players to build a 300 MW plant. The Association of Mindanao Rural Electric Cooperative Inc (AMRECO) project seemed exactly the type of process the EPIRA was designed to enable, yet it has struggled for several reasons (none related to the security situation).

Lantau Group analysis
Installed capacity shares by owner in the Philippines, 2012
Source: Lantau Group analysis

First, the ECs are not-for-profit entities and have no legal way to raise funds. The unforeseen consequences of this include their inability to hire advisors to run the process – without international legal and financial advice, documentation has been far from world class. Nor can ECs provide the level of credit support a standard international investor might expect for a project like this.

Second, the regulator in the Philippines – the Energy Regulatory Commission (ERC) – still operates as though the market were un-reformed. Retailers need its approval before passing though power purchases to consumers. While this is not an unusual requirement; the ERC’s processes fit with neither the process nor timescales of an international tender for new power.

The ERC process is based purely on cost, without any concern for how retailers source power. In many jurisdictions, a well-run competitive process is, by definition, the source of the least-cost power and no further checks on price are applied. Worse, the ERC fails to approve these contracts quickly. In some instances, contracts have even expired, for term, before gaining full approval – a period of nearly five years.

With the AMRECO project, the ECs were unable to provide any certainty that the ERC would allow the price to be passed through. To protect themselves, they therefore set a clause that any changes by the ERC would be passed through in the contract – or a no fault termination would let both sides walk away without damages.

While the termination was theoretically a reasonable approach, the ERC was unlikely to reach a decision until the power station would be almost complete: a risk few IPPs would take.

EC credit risk, lack of funding and uncertainty over the tariff combined to put off investors. A poll of international lenders found they were unwilling to even discuss the project. It might seem obvious to then seek funding and/or assistance from one of the institutions set up in Asia for this purpose. But ‘anti-coal’ policies at both the ADB and the World Bank meant neither was interested in helping out.

International players locked out

So how does a small but essential new power station get built in this environment, when the government’s own legislation prevents it from offering a guarantee to bridge need and capability to deliver? What is the role of the World Bank and the ADB, if their environmentalism lets communities suffer in the dark? How can a market deliver new capacity when the regulatory framework falls behind commercial reality? So far, the only ‘solution’ for the Philippines has been to go local: local sponsors, local lending, local documentation, local risk. International players are, in effect, excluded.

Other Asian markets show a similar trend. Outside renewables, China essentially no longer has power projects with international sponsors: local companies with strong balance sheets and access to cheap debt have locked them out.

There will be consequences. The risks locals are taking on in Mindanao are not unique and have been faced by IPPs around the world since the eighties. For some projects, the lack of credit support and an inability to pay will have serious financial repercussions. Missing documentation will then make it unclear who is liable and how the project should be unravelled. And the lack of international lenders will mean these failures could hit the local banking sector especially hard.

In fact, the risks for projects in places like Mindanao are nothing new. A combination of a lack of sovereign guarantees with non-creditworthy counterparties was also seen in India after the Dabhol fiasco in the nineties. These prevented many projects from completing, as looks likely in Mindanao.

What is new, though, are the mechanisms for dealing with risks. Where the government and the lending community will not take the risks, the only place left is the sponsors’ balance sheet. Unlike in the eighties and nineties, local sponsors will now take risks in their own countries that international players deem unworkable. This has brought a new type of player to the power market: the large local company taking risks that international power companies will not.

China has no IPPs for conventional plant because Chinese state owned enterprises (SOEs) have pushed them out. The SOEs have the advantage of state debt and a much lower need for return. In India, players such as Reliance and Tata have stepped into the gap once occupied by international IPPs. The Philippines now has wholly local companies such as Aboitiz and San Miguel, along with firms such as GN Power, where local know-how blends with a small international element. In Vietnam, Petrovietnam has long been a strong player in power. In Thailand, ECGO is even exporting its expertise.

Generation capacity in the Philippines
Source: BP and WESM

Local companies understand the culture and add no risk premium for being overseas. Back in the ‘bad old days’, companies would add a ‘risk factor’ to all their required rate of return calculations according to the country in question. As much as objective criteria, this risk factor could reflect a lack of comfort about doing business in a strange environment. The USA, for example, had a very low risk factor because companies felt they knew what they were doing there. The truth turned out to be quite the opposite. Local companies do not need this uplift and are thus more competitive.

Local companies are better placed to understand their market’s politics and regulatory drivers and are perhaps better at managing these risks. Where the firms exist in a related industry, they can gain finance based on relationships with local banks rather than the strength of project documentation. Arguably, local companies are also more comfortable with their own currency risks.

Will the cycle repeat?

This new context suggests two conclusions. The first is that the ‘international’ power producer is no longer such a valued commodity and many countries have learned to build power stations on their own. To find opportunities, international players need either to find niches where old constraints remain and where they can bring a technological advantage, or to find ways to ‘go local’.

Unsurprisingly, people are now talking about Myanmar or Ulaanbaatar – places that could grow fast and need capital but still lack the local industry to pick up the baton.For now, environmental concern and a push for more renewables remains the new frontier for IPPs. Projects are smaller but international players still bring expertise, equipment and funding that many markets need – although it is unclear for how long (China already exports solar and has growing wind expertise).

The second conclusion is more speculative. IPPs seem less necessary and structures have altered, in line with a rise in local sponsors and local lending in many markets, along with an expansion in alternatives to traditional PPAs. But the underlying risks are unchanged. The technology may not work well. The cost of fuel can still rise or the cost of competing fuels can fall. Demand may not rise or revenues from the market or local contracts can fail to cover costs. And, once built, most power stations still cannot move to find a better market.

It remains an open question whether local sponsors and local financing are solving these risks, or just passing them back to shareholders, who may be unsophisticated. It is still unclear whether ‘difficult’ projects such as AMRECO will go ahead at all – and when governments will reach breaking point, as the lights go out for hours, days or weeks at a time.

In the early nineties in the Philippines, some very lucrative deals were struck when power was desperately needed in short delivery times. Only time will tell if the cycle will repeat – and only those close to the game will recognise the signs and be able to profit. In other words: ‘you have to be in to win’.