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.