IPPs: currents of discontent

With the recent increase in electricity tariffs, there is renewed debate over the rationality of capacity payment charges (CPC) to independent power producers (IPPs).

Previously, only a few voices raised concerns about these charges, but now the debate has expanded, and nearly everyone outside of the treasury benches is discussing the need to renegotiate the capacity payment arrangements with the IPPs to lower electricity tariffs.

The government is in a catch-22 situation. The high cost of electricity has become a contentious political issue, with opposition parties leveraging public dissatisfaction to criticize the incumbent government’s handling of the energy sector. Industrial bodies like the FPPCCI and APTMA are demanding a renegotiation of contracts with the IPPs to lower electricity tariffs so that industry and manufacturing remain competitive.

In the past, the government could have deferred passing on the CPC in the electricity bills, making them part of the energy circular debt, and thus calming the situation. However, to secure the next bailout programme with the IMF, it cannot defer passing on CPC to the consumers. The IMF’s financial assistance is tied to strict fiscal discipline and structural reforms, which include reducing subsidies and increasing cost recovery in the energy sector. These conditions pressure the government to pass on the high costs of electricity to consumers, exacerbating public discontent and economic strain. 

Before discussing the way forward, let’s consider how we got here.

The evolution of IPP policies in Pakistan can be broadly categorized into three main phases: the 1994 policy, the 2002 policy, and the 2015 policy. Each of these policies has had distinct features but shares some common elements that have influenced electricity tariff determination.

Pakistan’s reliance on IPPs dates back to the Power Policy of 1994, introduced to alleviate the chronic energy shortages that plagued the country. The policy aimed to attract private investment by offering generous terms. The return on equity was set at an attractive 18 per cent, indexed to the US dollar, with a provision to include capacity payments. These payments are fixed charges made to IPPs to ensure the availability of electricity capacity, regardless of actual electricity generation or consumption. While this model provided the financial security necessary to draw private investors, it laid the groundwork for future challenges, including high-capacity payments and an over-reliance on expensive fossil fuel-based energy.

In contrast, the 2002 policy aimed to correct some of its predecessor's inefficiencies by reducing the return on equity to 12 per cent. This policy sought to balance investor interests with Pakistan’s economic realities, but it continued the trend of indexing returns to the US dollar. This indexing remained a double-edged sword, protecting investor returns from local currency depreciation while exacerbating the financial burden on the government (read consumers) whenever the rupee weakened.

The 2015 policy introduced further refinements, emphasizing a more diversified energy mix, including renewable energy sources. While this policy continued to offer returns indexed to the US dollar, it also aimed to attract investment in cleaner energy projects. Despite these positive changes, the legacy issues of high-capacity payments and over-invoicing persisted, largely due to the entrenched structures and practices established by the earlier policies.

Comparing these policies reveals several similarities and consistent challenges that have affected electricity tariff determination. All three policies maintained the practice of offering returns indexed to the US dollar, which, while attracting foreign investment, also made the energy sector highly sensitive to exchange rate fluctuations. This indexing has significantly contributed to the rising electricity tariffs, as the depreciation of the Pakistani rupee has consistently increased the financial obligations to IPPs.

Furthermore, each policy has struggled with the issue of overcapacity. The generous terms offered under the take-or-pay agreements have led to an installed capacity that far exceeds actual demand. This overcapacity results in higher per-unit costs for electricity, as the fixed costs of capacity payments are spread over a smaller-than-expected consumption base. Consequently, consumers face higher tariffs, contributing to economic strain and reducing industrial competitiveness.

Another issue that all three IPP policies failed to handle is over-invoicing on capital goods in some instances. Such artificially inflated project costs lead to perpetual returns on ‘ghost equity’ that burden the economy without corresponding benefits. Additionally, allegations of misreporting and overbilling by IPPs, such as overstated operational and maintenance margins, have further inflated costs and strained the energy sector.

The flawed contractual arrangements have contributed to a spiralling circular debt, reaching Rs2.64 trillion as of February 2024. This debt cycle exacerbates financial instability and hampers economic growth. The surge in electricity tariffs has led to premature deindustrialization, making Pakistani exports less competitive in the global market. High electricity costs strain both households and businesses, reducing overall economic productivity and growth.

From the IPPs’ perspective, capacity payments assist in servicing their debt and recovering capital expenditures, ensuring financial viability and continuous operation. These payments also ensure that power plants are available to meet peak demand and emergencies, thereby maintaining grid reliability and avoiding blackouts.

One appreciates the IPPs’ perspective. However, that does not help the tariff-stricken consumers who are staging sit-ins to revoke these contracts. The contracts are backed by sovereign guarantees from the government of Pakistan, and unilaterally revoking the contract can land the country in trouble. Even renegotiating the agreements is inherently challenging for several reasons. Besides the issue of sovereign guarantees, renegotiation can undermine investor confidence, deterring future investments not only in the energy sector but across the broader economy.

Third, the complexity of the contracts, which often include multiple stakeholders such as local and international investors, financial institutions, and government entities, complicates renegotiation efforts. Achieving consensus among all parties on revised terms can be a protracted and contentious process. Finally, the entrenched interests and potential resistance from powerful IPP lobbyists pose significant political and bureaucratic hurdles.

Having said that, the PTI government renegotiated with a few IPPs, leading to reduced returns on equity and capping the dollar exchange rate at Rs148. However, the overall impact of these renegotiations was mixed. While there were some immediate financial reliefs, the fundamental structural issues remained unaddressed, and the benefits were not as substantial as hoped. The PTI government was unable to persuade the Chinese Independent Power Producers (IPPs) to renegotiate. Reportedly, the Chinese asked Pakistan to first renegotiate with the local IPPs (the complete list of which and their owners are now in the public domain), reach an agreement, and then engage in similar discussions with Chinese investors.

The current government has also approached Chinese IPPs for a renegotiation and is awaiting their response. However, two things should be kept in mind. First, Pakistan has not yet renegotiated with the local IPPs. Second, it should not expect any favours from China just by making a noise about it. CPEC is a small part of the broader Belt and Road Initiative (BRI). If China extends any favours to Pakistan, it may need to do the same for its other BRI partners. Therefore, Pakistan needs to pursue closed-door diplomacy to obtain any concessions from Chinese IPPs, and this should happen after successful renegotiation with the local IPPs.

The political implications of the controversy surrounding capacity payments to IPPs are equally significant. The burden of high electricity tariffs falls disproportionately on the middle and lower-income segments of society, fueling public outrage and eroding trust in the government’s ability to manage the economy. The controversy also exposes the challenges of governance and accountability in Pakistan's energy sector. Addressing these governance issues is crucial for restoring public trust and ensuring the sustainable development of the energy sector.

In the best-case scenario, successful renegotiations with both local and international IPPs could lead to significantly lower electricity tariffs, increased industrial competitiveness, and enhanced public trust in the government's ability to manage the economy.

In the worst-case scenario, failed renegotiations could exacerbate the financial strain on the government and consumers, leading to higher electricity tariffs, crippling industry, and increased public unrest. Any deviations from IMF conditionalities to appease public sentiments will endanger Pakistan’s next IMF programme, jeopardizing its macroeconomic stability.

In the business-as-usual scenario, the government may continue to struggle with piecemeal solutions and temporary relief measures. This would likely maintain the status quo of high electricity tariffs and periodic public discontent.

The prime minister takes pride in choosing economic revival over politics. Let's see how this translates in the energy sector.

The writer heads the Sustainable Development Policy Institute.

He tweets/posts @abidsuleri