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Dr Kamal Munir
Dr Kamal Munir

From time to time Dawn invites people with stakes or expertise in any area of the economy to contribute their thoughts on issues of pressing concern. Today we invite Dr Kamal Munir, a professor of strategy & policy at the University of Cambridge and Salman Khalid, an emerging markets investment professional and a former Fulbright Scholar, to reflect on the rising costs of power in Pakistan.

The PTI government seems to have had a bit of a stumbling start to their inning. Only a few months in and already several decisions have been taken and reversed. Learning on the job is not necessarily a bad thing as long as the outcome is the intended one. However, what makes us worry is that the economic policies so far seem to be fairly conservative with too few steps being taken to dismantle the pernicious rent-seeking regimes that have long been stifling the development potential of the country.

Perhaps no sector of the economy is more important at the current juncture than power generation and distribution. The price of electricity feeds into everything, and the escalating cost is crippling Pakistan’s industry.

If this government is serious about fixing this sector, and reversing the rot that has set in, it needs to demolish the biggest myth previous governments have been peddling. This myth suggests that the energy crisis is essentially a product of user subsidies, stealing of electricity and distribution losses. The World Bank, IMF and many advisers to the government have been at the forefront of creating this myth. The reality is that rather than users, it is the producers who are being generously subsidised and that is where the government will have to intervene if they wish to ever reverse the rot.

The prevailing energy policy in the country, which previous governments have done precious little to change, offers Independent Power Producers (IPPs) guaranteed equity returns (around 15-18 per cent in dollars, and even more in recent CPEC projects) - backed by sovereign guarantees. The government of Pakistan is contracted to buy whatever they produce and pay all their fixed costs – including maintenance, operating and financing costs — and adds a lucrative return on top. In other words, they do not need to compete with anyone to ‘earn’ their profits. Only 20-25pc of the plant cost is contributed by the investors with the balance raised in debt which is repaid/guaranteed by the GoP. This is a textbook example of rent-seeking.

There is more. Due to poor oversight from our government, over-invoicing is rife, meaning that actual investment and operations cost (including fuel consumption) is often overstated. The net result is that the investors make far higher returns on their investment than the already generous policy intended. Instead of addressing the structural inefficiency of the policy, successive governments have instead offered ever higher returns to attract investment in the sector, with recent CPEC-related projects contracted at up to 27pc returns on equity, in USD terms. As a result, the price of power is much higher than it need be under this monstrous policy, thereby exacerbating the problem of theft, non-payment and feeding into “circular debt”, which has increased uncertainty and investor risk in the sector.

Since the contracts are normally of 25 year duration, how does one minimize the damage this policy regime is likely to do in the remaining years? Here is one way to do it: given the historical IPP agreements, the government is liable to pay the financing cost of the IPPs (around 80pc of the project cost) and guaranteed equity returns anyway. The financing cost is generally repaid within the first 10 years of the plant becoming operational which means that the cost to the government is much higher during this period. As a result, the plants from 1990s (around 6000MW) today have no debt while the plants from the 2000s (around 3000MW) have a few years of debt re-payments left while almost all of the repayment is outstanding for the new projects (6000MW).

We believe that there is an arbitrage opportunity here to lower the cost to the government. The government should establish a “Pakistan power sector financing fund (PPSFF)”, an entity which would be backed by sovereign guarantees of the government and will be able to raise cheaper local currency financing compared to more expensive debt held at the IPP level (often 3pc more than governments borrowing rate in local currency). The IPP debt will be refinanced by PPSFF (all other terms remaining the same) thereby reducing the cost to the government. The important point to note is that this option creates no additional debt burden on the government as it is contracted to repay it already. The foreign currency debt would be a secondary focus dependent on availability of cheaper dollar financing through government-to-government lines or other means.

Salman Khalid
Salman Khalid

The second intervention of PPSFF will be to retire some of the equity held at the IPP level. Currently IPP shareholders are required to contribute at least 20pc of the total project cost on which they are being paid very generous returns pegged to USD. This requirement can be reduced to 10pc and the balance of the equity retired and replaced by PPSFF financed debt in PKR. The shareholders will get a one-time extraordinary dividend which they can deploy in new investments. This will result in substantial savings for the government by replacing more expensive dollar-denominated equity return liability by a cheaper rupee-denominated debt. Given significant currency depreciation per annum over the long-run, the savings will only increase with time. The government will be able to pass on lower tariffs to the consumers as a result of these savings.

This is a voluntary mechanism which benefits all parties involved in the power sector (government, IPPs, ordinary consumers, industry). The government can nudge the IPP investors by offering incentives such as preferential settlement of their over-due receivables as part of the circular debt pile-up should they agree to the above mechanism. We can only hope the government is willing to go beyond accepting the cost structure of the historical power portfolio as a fait accompli and entertain novel ways of fixing this mess.