The Mirage of Three-Cent Power

Why the Haripur project would cost more than five cents here

Back in 1998, when participation by IPPs in power generation was still at a nascent stage in India, the discovery of ultra-low tariffs for a project in neighbouring Bangladesh made headlines. Opponents of private power questioned why foreign IPPs were “overstating” their tariffs in India, without factoring in the higher import duties, fuel costs and taxes in the country. This article analyses the tariffs quoted by IPPs in India and elsewhere in the world…

It all started in January 1998. The Bangladesh Minister of Energy announced that the AES Corporation had won the bid to build, own and operate a 360 MW gas-fired combined cycle plant at Haripur, 12 miles south east of Dhaka. AES had apparently quoted a tariff of 2.8 cents per unit.

The opponents of private power jumped on this piece of news and accused IPPs in India of overcharging. Even the Ministry of Power asked the developers to explain why the tariffs in India are higher.

Never mind the fact that the Haripur project was going to use natural gas supplied by a Petrobangla subsidiary at almost half the price in India. That there would be no import duties on equipment versus 22 per cent customs charges in India. And that the tax holiday in Bangladesh would last 15 years, not five as in India.

That is not all. The financing of the Haripur project would have World Bank support. The tenor would be longer and the interest rates lower than those paid by the Indian IPPs. Further, the project would have tight guarantees from the Government of Bangladesh.

In addition, significant predevelopment work on the Haripur project was completed by the authorities prior to inviting bids. This would not only reduce the development time but also lower the level of risk perceived by the lenders

So, an explanation need not have been sought. The answer is actually quite simple. The tariffs in India are higher than those quoted for the Haripur project because of higher import duties, higher fuel costs, higher taxes and higher financing costs.

To illustrate this point, Power Line Research has analysed the Haripur project (with the help of industry experts) and computed the tariff for a similar project in India after adjusting for the “Indian” parameters.

The analysis shows that these four factors alone will hike the tariff to well above five cents, even if everything else is the same.

There are other points to consider, too. It is possible that AES may have been willing to settle for a low rate of return for strategic reasons. Perhaps to use the contracted resources rendered idle by events in east Asia. Or even perhaps to build a showcase project close to India. Meanwhile, the Bangladesh power authorities are negotiating PPAs with other IPPs, which involve tariffs as high as five cents.

The country may suffer from shortage of power. But it certainly does not suffer from shortage of controversies about the power sector.

The latest controversy that threatens to put a cloud on many IPP projects involves allegations that these developers are overcharging. That the price of IPP power in India is much higher than that in other countries

The new Minister of Power himself has alluded to these charges at several meetings and stated the need for more “reasonable prices. The ministry has asked several developers to explain their pricing.

This issue has raised its head just as a number of IPP projects were beginning to approach financial closure. As of now, it seems, the controversy will not adversely affect these projects. But given the fast and furious nature of Indian politics, who knows when that might change.

And, further delay in IPP projects is one thing the country cannot afford. It is therefore important that the key questions that have been raised are answered. Does IPP power cost more in India? If yes, what are the reasons for the higher price? And finally, what can the government do to reduce these costs?

Let us begin with the first question. Does IPP power cost more in India? The answer is yes and no. It does cost more than it would in a developed country like the US. But it does not cost more than it  would in other developing countries, with very few exceptions.

For example, most IPPs in Indonesia signed over the last couple of years have been in the range of 6.5 to 7.5 cents per unit. Even after the currency crisis and the decline of the rupiah, the latest PPA signed in Indonesia for the Tanjung Jati C power project quoted a price of 5.73 cents per unit. This despite the fact that the fuel used by the plant would be supplied at a relatively low cost.

Similarly, the recent negotiations between the Thailand buyers and Laotian suppliers have centred on a tariff of 5.7 cents per unit. The source of power is hydro plants. Most of the older contracts in Thailand have been signed at a tariff higher than 6 cents per unit.

Closer to home, most IPP projects in Pakistan v ere signed at a tariff of 6.5 cents per unit. Some of the earlier ones had an event higher tariff.

In fact, most PPAs signed over the last two years in other emerging countries have been in the range of 6 to 8 cents per unit. This despite the fact that, in general, the fuel costs and import duties are lower than in India.

To be sure, there are exceptions. There are also good reasons for these exceptions. One project that does have a much lower tariff is the Haripur project in Bangladesh. The tariff on that project is only about 2.8 cents per unit. But as the analysis on the opposite page shows, there are very specific conditions that have led to this low price. The Indian parameters raise the costs. The same project executed in India would have cost well over 5 cents per unit.

The same is also true of a recent project in Egypt, where the winning bid was 2.6 cents per unit. This project too involved a low fuel price and World Bank funding support.

Thus it can be safely said that, but for a few exceptions, the Indian IPP price range of 5 to 6 cents per unit is definitely not higher than that in other developing countries.

Developed countries like the US and the UK do have lower tariffs. Again, the difference in the tariffs is accounted for by the difference in the parameters that define the IPP projects.

The cost of funding in these countries is much lower. Lenders perceive very little risk. The buyers are financial sound, unlike our own state electricity boards. Equipment costs are much lower because the local manufacturers do not have a monopoly and are not protected by import tariffs. Fuel costs are also much lower for the very same reasons. And the IPP developers do not have to build support infrastructure.

Yet, the price of power from new plants is not that much lower. A gas-fired combined cycle plant in the US would probably generate and sell power at a bulk rate of about 4 cents per unit.

In fact, the average wholesale price in the UK transmission system last year (with power supplied from both old and new plants) was about 4.5 cents per unit.

Even though these tariff comparisons are not necessarily unfavourable, the costs could be much lower in India but for some factors that can charitably be called “Indian parameters”.

The first one of these parameters is the high import duties. The customs charge on the equipment import of a power project is about 2 2 per cent. This does not include sales tax. The capacity charge component of the tariff is thus automatically raised by 22 per cent.

If the government is serious about reducing the price of electricity, this will be a good place to begin. The trouble is that the government wants to protect local manufacturers like BHEL as well. In addition, the customs department also wants its slice of the pie. The consumers end up paying the price.

Then there is the fuel cost and taxes. The IPPs again have to deal with the monopoly mindset of the public sector oil producing units. They end up paying not only prices higher than those prevailing internationally, but also additional so-called infrastructure charges. And on top of that, import duties on fuel.

The fuel costs are a pass through. The only parties that suffer from the rise in price are either the consumers or the SEBs, who may not be able to pass on the higher cost.

The poor state of finances of the SEBs also raises the cost. International lenders are hesitant to finance IPP projects whose sole source of revenue is the SEBs. If they do agree to lend, they ask for a premium that reflects the high perceived risk. The price of IPP power is directly related to the perceived level of risk.

The financial position of the SEBs is not the only factor contributing to high risk. Long delays in clearances, the multitude of the ministries whose sanctions are needed, corruption and the threat of renegotiation, all increase the level of perceived risk and thus the cost and the price of IPP power.

Of particular concern to financiers is the lack of consistency and clarity in government policies. Whether it relates to choice of fuel or method of project evaluation, it keeps changing the rules of the game. This again increases the level of perceived risk.

The long development time also increases the costs incurred by IPPs in a very direct fashion. Some IPPs have been waiting for the final word or their projects for almost six years. The cost of maintaining an office staffed with expats or senior Indian executives can run into millions of dollars per year. The documentation required by the CEO also adds to the bill.

The higher the perceived le el of risk and the development costs, the higher is the return sought by the IPPs. If we could reduce the level of uncertainty and reduce the length of the red tape, perhaps IPPs could work with a rate of return lower than 16 per cent.

The fixed rate of return is probably the single biggest reason for delays and perhaps higher costs as well. The cost-plus approach provides no incentive to the IPPs to cut costs. Their only concern is approval of these costs by the CEA.

Once the project costs are approved, the developers have no incentive to try to renegotiate deals with their suppliers and bring down the prices. In fact, in some cases, they could be penalised.

The cost-plus approach also focuses on the so-called hard costs. It is possible to reduce the overall cost of the project by having a slightly higher hard cost component but much lower soft cost component. Under the current method of project evaluation, IPPs could be penalised for going this route, Overlooked is the fact that the tariff is a derivative of the total project cost, not just the EPC cost which is the focus of the CEA attention.

The number of approvals required also increases the opportunities for corruption. The concerned officials may demand bribes. The focus on cost-plus also creates opportunities for the developers to indulge in over-invoicing. The projects should have been evaluated on the basis of the proposed tariff, rather than the proposed cost. This is the approach followed in most other countries, developed and developing.

We may also have gone wrong by preferring the IoU route to the competitive bidding route. This, however, is somewhat debatable.

In principle, the higher the level of competition, the lower will be the price. This approach, however, requires a sound prequalification of the bidding parties. The Indian experience, so far at least, has produced mixed or negative results

Comparative analysis

Haripur Project Cents/unit
Capacity charges 0.97
Energy charges 1.91
Total 2.88
Impact of “Indian” parameters
Import duties on equipment +0.12
Support infrastructure +0.13
Corporate taxes +0.30
Non-World Bank financing +0.60
Fuel cost +0.41
Fuel duties and taxes +0.62
Additional tariff needed to meet RoE requirements in light of higher capital cost +0.20-0.30
Total impact +2.38-2.48
What it would cost in India
Capacity charges 2.32-2.42
Energy charges 2.94
Total 5.26-5.36

Note on the above analysis: The base case capacity charge was taken as 0.9706 cents/1‹Wh as per the AES bid. The project cost was then adjusted for import duties on equipment and other Indian taxes. The increase in project cost due to this factor was estimated at USS31.73 million. This would result in additional debt and equity funding requirements. Additional infrastructure requirement was assumed to be US$28 million for the construction of roads, fuel receiving facility, etc. This further affected the debt service charge and the equity return. The RoE was further adjusted for corporate taxes assuming Indian taxation laws. Haripur financing has World Bank support with long tenors and lower interest rates. This was adjusted to suit Indian conditions by changing the debt parameters. We then calculated additional tariff needed to meet return on equity requirements in light of higher capital costs. This number is a gross calculation and should be used with caution. The base fuel price as per the Haripur bid was S2.55/GJ fS2.69/MMBTU) and the variable 0&M was 0.046 ps/kWh. This was adjusted for the Indian fuel price of S3.3/MMBTU plus taxes (net $4.23/MMBTU). Please note that we have “levelised” the Haripur tariff using a 22-year projection for each of the tariff elements.

Several states that went for competitive bidding ended up awarding projects to promoters who had no previous power sector experience and did not know what they were in for. These promoters bid low prices but when the project was awarded to them, they could not get the financing. As a result, many of these projects are still on paper and states continue to suffer from lack of power.

For example, Rajasthan went for competitive bidding. The lowest bid price was Rs 2.10 per unit. All IPPs who were awarded the projects had to supply power at this price. At the time, this heralded a major breakthrough. However, two years later, none of the projects is anywhere near ready to get off the ground and the state government continues to look for other, more expensive sources of power.

The problem with the competitive bidding route is that unless it is supervised with proper expertise, we end up with projects which have low prices but no chance of implementation. Credible projects with reasonable prices have a risk of being shut out by suspect bidders with unrealistically low prices.

If the government is keen on reducing the price paid by the consumer, it can do so by a few simple steps. Eliminate import duties Do away with the monopoly of fuel sellers Focus on tariff and not cost. And do everything it can to improve the financial health of SEBs.

One final note. This write-up has focused on factors that drive up costs in general. To be sure, there are projects where the tariff is high because of over invoicing or over-charging. No one doubts that this does sometimes happen. Those projects do need to be questioned. It is important, however, to make sure that focusing on these exceptions does not affect and delay the other projects. Otherwise, more than the developers, it will be the Indian consumer who will end up suffering all over again.

 

 

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