Tuesday, July 22, 2008
Capital market
FINEX
Business World
With-out much fanfare, a very important bill has been passed in the bicameral conference before Congress adjourned last month - the Personal Equity Retirement Account (PERA).
The bill provides tax incentives for long-term savings that will help fund long-term investments. In the works for several years now, it is puzzling that the President has not signed the bill into law yet. It would have made a perfect pasalubong to our kababayans when she visited the US. The law-in-waiting provides a maximum PERA annual contribution to the tax-free savings account of P100,000, and in the case of Overseas Filipino Workers, double this amount.
Institutions active in the Capital Market Development Council jointly chaired by the secretary of finance and a private sector representative (former Finex President Dave Balangue) are hoping for the passage of another important bill for development of financial markets - the Credit Information System Act (CISA). This bill is critical to financial market development because it will facilitate and lessen the cost of lending. With the mandatory submission of standard credit information on a timely manner, credit evaluation will be much easier.
As observed in a recent IFC paper, credit bureaus are essential elements of the financial infrastructure that facilitates access to finance. In particular, improved credit information helps increase the likelihood of small businesses being able to access credit. As much as 49% of small entrepreneurs reported high financial constraints in countries without credit bureaus, vs. only 27 percent for those that have them.
The bill has passed third reading in both chambers. But players in the financial market have raised important concerns over revisions in the features of the bill. In particular, the House version provides for a Credit Information Corporation to be 60% owned by government. This subjects it to restrictions on budgetary appropriations, bidding, and salary standardization law - a sharp departure from the public-private partnership that was the anchor for the original bill, and that has been found to work in other contexts.
Of even more serious concern is the regulatory framework. The original bills provided for the BSP to be the regulator, given that it supervises the majority of credit providers and has an overarching responsibility and enforcement power over credit matters. Instead, the bills now look only to the SEC to be the sole regulator. To be fair, it is an institution that is quite competent as well, but it has more general responsibilities in overseeing corporations.
As the IFC study noted, the role of the supervisor is crucial.
"It is the supervisor's role, as a trusted, reputable third party, to play the role of setting an enabling environment for credit reporting to flourish. By establishing the right regulatory environment, increasing cross-sector participation and hence the number of lenders contributing information and the quality of information they provide, many other variables - sector competition, increased sophistication of lenders, quality and pricing of bureau services, usage penetration and overall development and efficiency of infrastructure - will follow an outward expansion through market forces. "
The twin problems of (a) having a start-up institution which has the usual limitations covering government corporations and (b) leaving out the BSP from the regulatory framework are expected to impair the development and effectiveness of the institution in pursuing its mandate from day one of its corporate life. We are hopeful that the sponsors of the CISA bill in both houses can address these concerns in the bicameral committee and hammer out, on the back of the passage of PERA, a double win for financial and capital market development.
Thursday, July 17, 2008
Power struggles
ANALYSIS
Business World
Since its passage in 2001, the Electric Power Industry Reform Act (EPIRA), the law setting out the restructuring of the power sector, has gone through a slow start and progressed in what seems like fits and spurts.
The year 2007 turned out to be one of the good years. Government, through the Power Sector Assets and Liabilities Management Corporation (PSALM), was able to dispose of some of the large generating assets, most notably two coal-fired power plants, Masinloc and Calaca, each with a rated capacity of 600MW. It also managed to off-load via a concession agreement the Transmission Company, whose franchise from Congress is expected to pass this year. This is something that it had failed thrice to do.
By the end of 2007, having privatized over 40% of generating assets, government finally came within sight of its 70% asset sale goal.
Nevertheless, after PSALM opened up other generating assets for sale in the early part of 2008, a sense of uncertainty settled anew over the industry. In a biting article that pieces together developments in the past months, the Wall Street Journal comes to a view that government is backtracking on its commitment to privatize the electricity industry. However, a less pessimistic, though still worrisome picture emerges from discussions with local players knowledgeable about the industry.
Distorted price signals
From what we gathered, the latest deadlock is more likely linked to recent developments in electricity pricing that highlight weaknesses in the spot market and the regulatory environment, which can be expected to lead to a withdrawal of investor interest. In the last two months, spot prices at the Wholesale Electricity Spot Market (WESM), the country's power trading platform, dropped sharply to their lowest levels since the start of operations (Chart 1), reportedly falling below the variable operating cost of an efficient coal-fired power plant. From all indications, the price drop was likely the result of the market's thinness, which makes prices susceptible to swings in the bids of a small group of players, mostly still government, operating under a weak or non-existent incentive framework at this time.
Also last June, the Energy Regulatory Commission (ERC) decided that the National Power Corporation (NPC) should reduce electricity tariffs by 71 centavos per kilowatt-hour (kWh) in Luzon, the country's largest power grid. This appeared to have been a surprise to NPC. The decision was in response to NPC applications for (a) a reported 37-centavo increase in its basic generation charge and (b) a 40-centavo decrease in pass-through costs related to fuel, purchased power and currency adjustments from an earlier period (2006), or a net reduction of 3.62 centavos/kWh. The ERC decision was based only on the second request, applying in addition "carrying costs" to account for the delay in implementation. It has yet to act on the application to increase generation cost.
While it would be tempting to read more into the twin price cuts, we think, based on discussions with industry experts, that these are in fact independent developments rather than politically driven populist moves. The WESM, created in June 2006, continues to suffer birth pains, related largely to the market dominance of government trading teams, that have affected its efficiency in price discovery.
The ERC, order on the other hand, appears to be a delayed and ill-timed ruling for past adjustments. Apparently, electricity tariffs, which were supposed to adjust with exchange rate movements, failed to do so when the peso was appreciating in the 2006-07 period. Given the time lag and in light of current high fuel costs, there had been informal agreements with the regulator to stretch out the refund of overcharges over a longer- than-prescribed time period so as to maintain electricity tariffs near the industry's "long-run avoidable cost," or the generation cost of the most efficient new entrant, approximated at P4.30/kWh. However, ERC decided in the end to play by the rules, applying the prescribed six-month recovery period, thus ordering a much larger rate reduction. This had the effect of distorting price signals, considering that markets have moved on since 2006, which reduces incentives for conservation. NPC is reportedly now challenging the reduced rates.
Risk to public finances
From the viewpoint of NPC finances, the larger-than-sought for rate reduction may not be deleterious, considering past over- recoveries, if NPC were operating in a more mature regulatory environment. Under the rules, input costs may be recovered through a rate adjustment mechanism implemented on a quarterly basis. Given the unpredictability of regulatory decisions, however, a tariff increase in a time of economic hardship may not be guaranteed. Hence, it would be more prudent to consider a lump-sum payment for refunding accumulated overcharges, rather than tinker with the tariffs.
There remains, however, the question of NPC's basic generation rate, which reflects the operating cost of its mix of power plants and is where profits are embedded. The gap between the current rate, i.e., P3.89/kWh, and the P4.30/kWh long-run avoidable cost, already significant, is growing.
By one estimate, recent cost increases brought about by high fuel prices have pushed the number up to as much as P4.45/kWh. If fuel costs stay at current levels or worse, continue to rise, ERC would have to act on NPC's rate increase application. Not doing so would risk the public sector's fiscal health as has happened prior to late 2004.
An important consideration too is that not only are private players looking at WESM rates, the prices of transition supply contracts attached to some of the generating assets sold are linked to NPC rates and are thus exposed to rising raw material costs. These transition supply contracts were meant to increase the value of the assets by assuring winning bidders of a ready market for power generated.
Already, local banks, which currently have large exposures to the power industry, are worried about the impact of low WESM prices on their borrowers' profitability. Insiders noted that the two newest entrants into the power market, AES (which bought the Masinloc plant) and Suez (Calaca plant), sell 30% and 25%, respectively, of their excess capacities through the WESM.
Meanwhile, the problems of the Manila Electric Company (Meralco), which accounts for about 60% of electricity sales in the Philippines, are a separate issue altogether. As of March 2008, government, through five of its agencies, owns about one-third of Meralco.
Risk to privatization
Another concern is that recent developments may derail government's privatization program.
Receipts from the sale of generating assets have been a major source of income for the public sector. Last year, PSALM earned over P20 billion from privatization-related activities.
On the side of the private sector, those who have already bought into the sector are concerned that open access, ushering in full competition where electricity buyers of a certain size can freely shop for suppliers, may not happen soon enough. Government is aiming to complete 70% of its privatization program by end-2008, a prerequisite for open access. In light of recent developments, industry players have grown doubtful that this will be achieved.
This would be a pity as fast-tracking privatization, which would bring in the critical mass of players and hopefully impose more discipline in the regulatory structure, appears to be the only way to ensure that all the elements envisioned for privatization to work can come into play.
Overall, the risk of the prevailing uncertainty in the power sector is that more delays in the privatization program can potentially damage economic growth should the needed investments in power generation capacities fail to materialize. Not only is there a risk of returning to the rotating blackouts experienced in the early 1990s, but the fiscal cost of bailing out the economy from these blackouts may set economic growth back anew over the medium term.
Business World
Since its passage in 2001, the Electric Power Industry Reform Act (EPIRA), the law setting out the restructuring of the power sector, has gone through a slow start and progressed in what seems like fits and spurts.
The year 2007 turned out to be one of the good years. Government, through the Power Sector Assets and Liabilities Management Corporation (PSALM), was able to dispose of some of the large generating assets, most notably two coal-fired power plants, Masinloc and Calaca, each with a rated capacity of 600MW. It also managed to off-load via a concession agreement the Transmission Company, whose franchise from Congress is expected to pass this year. This is something that it had failed thrice to do.
By the end of 2007, having privatized over 40% of generating assets, government finally came within sight of its 70% asset sale goal.
Nevertheless, after PSALM opened up other generating assets for sale in the early part of 2008, a sense of uncertainty settled anew over the industry. In a biting article that pieces together developments in the past months, the Wall Street Journal comes to a view that government is backtracking on its commitment to privatize the electricity industry. However, a less pessimistic, though still worrisome picture emerges from discussions with local players knowledgeable about the industry.
Distorted price signals
From what we gathered, the latest deadlock is more likely linked to recent developments in electricity pricing that highlight weaknesses in the spot market and the regulatory environment, which can be expected to lead to a withdrawal of investor interest. In the last two months, spot prices at the Wholesale Electricity Spot Market (WESM), the country's power trading platform, dropped sharply to their lowest levels since the start of operations (Chart 1), reportedly falling below the variable operating cost of an efficient coal-fired power plant. From all indications, the price drop was likely the result of the market's thinness, which makes prices susceptible to swings in the bids of a small group of players, mostly still government, operating under a weak or non-existent incentive framework at this time.
Also last June, the Energy Regulatory Commission (ERC) decided that the National Power Corporation (NPC) should reduce electricity tariffs by 71 centavos per kilowatt-hour (kWh) in Luzon, the country's largest power grid. This appeared to have been a surprise to NPC. The decision was in response to NPC applications for (a) a reported 37-centavo increase in its basic generation charge and (b) a 40-centavo decrease in pass-through costs related to fuel, purchased power and currency adjustments from an earlier period (2006), or a net reduction of 3.62 centavos/kWh. The ERC decision was based only on the second request, applying in addition "carrying costs" to account for the delay in implementation. It has yet to act on the application to increase generation cost.
While it would be tempting to read more into the twin price cuts, we think, based on discussions with industry experts, that these are in fact independent developments rather than politically driven populist moves. The WESM, created in June 2006, continues to suffer birth pains, related largely to the market dominance of government trading teams, that have affected its efficiency in price discovery.
The ERC, order on the other hand, appears to be a delayed and ill-timed ruling for past adjustments. Apparently, electricity tariffs, which were supposed to adjust with exchange rate movements, failed to do so when the peso was appreciating in the 2006-07 period. Given the time lag and in light of current high fuel costs, there had been informal agreements with the regulator to stretch out the refund of overcharges over a longer- than-prescribed time period so as to maintain electricity tariffs near the industry's "long-run avoidable cost," or the generation cost of the most efficient new entrant, approximated at P4.30/kWh. However, ERC decided in the end to play by the rules, applying the prescribed six-month recovery period, thus ordering a much larger rate reduction. This had the effect of distorting price signals, considering that markets have moved on since 2006, which reduces incentives for conservation. NPC is reportedly now challenging the reduced rates.
Risk to public finances
From the viewpoint of NPC finances, the larger-than-sought for rate reduction may not be deleterious, considering past over- recoveries, if NPC were operating in a more mature regulatory environment. Under the rules, input costs may be recovered through a rate adjustment mechanism implemented on a quarterly basis. Given the unpredictability of regulatory decisions, however, a tariff increase in a time of economic hardship may not be guaranteed. Hence, it would be more prudent to consider a lump-sum payment for refunding accumulated overcharges, rather than tinker with the tariffs.
There remains, however, the question of NPC's basic generation rate, which reflects the operating cost of its mix of power plants and is where profits are embedded. The gap between the current rate, i.e., P3.89/kWh, and the P4.30/kWh long-run avoidable cost, already significant, is growing.
By one estimate, recent cost increases brought about by high fuel prices have pushed the number up to as much as P4.45/kWh. If fuel costs stay at current levels or worse, continue to rise, ERC would have to act on NPC's rate increase application. Not doing so would risk the public sector's fiscal health as has happened prior to late 2004.
An important consideration too is that not only are private players looking at WESM rates, the prices of transition supply contracts attached to some of the generating assets sold are linked to NPC rates and are thus exposed to rising raw material costs. These transition supply contracts were meant to increase the value of the assets by assuring winning bidders of a ready market for power generated.
Already, local banks, which currently have large exposures to the power industry, are worried about the impact of low WESM prices on their borrowers' profitability. Insiders noted that the two newest entrants into the power market, AES (which bought the Masinloc plant) and Suez (Calaca plant), sell 30% and 25%, respectively, of their excess capacities through the WESM.
Meanwhile, the problems of the Manila Electric Company (Meralco), which accounts for about 60% of electricity sales in the Philippines, are a separate issue altogether. As of March 2008, government, through five of its agencies, owns about one-third of Meralco.
Risk to privatization
Another concern is that recent developments may derail government's privatization program.
Receipts from the sale of generating assets have been a major source of income for the public sector. Last year, PSALM earned over P20 billion from privatization-related activities.
On the side of the private sector, those who have already bought into the sector are concerned that open access, ushering in full competition where electricity buyers of a certain size can freely shop for suppliers, may not happen soon enough. Government is aiming to complete 70% of its privatization program by end-2008, a prerequisite for open access. In light of recent developments, industry players have grown doubtful that this will be achieved.
This would be a pity as fast-tracking privatization, which would bring in the critical mass of players and hopefully impose more discipline in the regulatory structure, appears to be the only way to ensure that all the elements envisioned for privatization to work can come into play.
Overall, the risk of the prevailing uncertainty in the power sector is that more delays in the privatization program can potentially damage economic growth should the needed investments in power generation capacities fail to materialize. Not only is there a risk of returning to the rotating blackouts experienced in the early 1990s, but the fiscal cost of bailing out the economy from these blackouts may set economic growth back anew over the medium term.
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