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Mon 18 Oct 2010 04:00 AM

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Making privatisation work

Independent power projects are now the norm for newly installed power generation in the GCC. George Sarraf and Walid Fayad from Booz & Co. look at the potential pitfalls of the model.

Making privatisation work
Walid Fayad, principal at Booz & Co.
Making privatisation work
George Sarraf, partner at Booz & Co.
Making privatisation work
IPPs allow governments in the region to expand power generation capacity without large front-end investment.

Independent power projects are now the norm for newly installed power generation in the GCC. George Sarraf and Walid Fayad from Booz & Co. look at the potential pitfalls of the model.

Independent power projects (IPPs) and independent water and power projects (IWPPs) are a relatively new phenomenon in the GCC. Up until the mid-1990s, power plants in the region were exclusively financed and developed by governments and government-backed corporations. In the last 15 years, however, IPPs and IWPPs have proliferated across the region, starting with initial forays in Oman in 1996 and Abu Dhabi in 2002, and expanding to Qatar, Bahrain, Saudi Arabia, and recently Kuwait and Dubai.

Across the GCC, more than two dozen IPPs and IWPPs are now in operation, with a combined installed capacity of 20 gigawatts, in addition to the many captive power plants dedicated to serving specific industrial users. Current expansion plans will more than double the region's IPP and IWPP capacity over the next five years, bringing the privately developed share of aggregate electricity generation to about 34 percent.

The reason IPPs have almost entirely displaced the traditional public power plants for new generation stems from several distinct advantages it offers to governments:

Amortization of public expenditures: The GCC's rapidly growing economies and populations require enormous investment in infrastructure and other public goods. IPPs allow governments to install the power capacity they need without large front-end public investments.

Competitive cost of power: IPP bidders are evaluated on the basis of a levelised electricity cost; although cost comparisons with government-funded plants are inherently imprecise, IPP prices appear to be competitive, despite higher financing costs.

Predictable timing and often faster execution: IPP developers have strong discipline in bidding, financing, designing, building, and commissioning plants, as well as cost incentives to begin producing power as quickly as possible.
Establishment of performance benchmarks: IPPs provide operational and financial benchmarks that can raise the game for all power plants, especially those operating in identical environments.

Promotion of a favourable business environment: IPPs create private-sector employment opportunities and engage an array of stakeholders - local and international banks, investors, and export credit agencies - whose health and vitality are critical to the region's continued growth.

Pitfalls of the IPP model

The fundamental risk of the IPP model stems not from individual projects but from the long-term aggregate effect of applying the model exclusively. Rational choices at the case-by-case project level can lead to unwanted consequences at the sector level. Policymakers need to be conscious of the potential limits to the advantages that IPPs provide.

The first and most obvious limit is inherent in the practice of amortizing present investment. GCC nations are tying up increasing shares of GDP in explicit and implicit IPP or IWPP obligations.

This is not necessarily a bad thing if governments use the immediate savings to create growth in national wealth that exceeds the accumulating liabilities. However, the power purchase commitments made in today's growth period could prove onerous to a future economy that may find itself with an abundance of capacity.

A second long-term risk concerns the fact that IPPs are biased toward providing base-load power, which could ultimately leave system planners struggling to meet daily and seasonal fluctuations in demand. A power system requires a diverse portfolio of generation technologies in order to serve the
variable electricity needs of a population efficiently.

The third risk of IPP dependence is that it can inhibit the natural evolution of the power sector toward increased liberalisation. If the current trajectory of IPP investment continues, GCC nations may find within 10 years that a major portion of their generation assets are locked down in long-term power purchase agreements (PPA) contracts. Such a situation would substantially compromise the flexibility of the power system to adapt to market forces.
Avoiding the obstacles

GCC governments can counter and even avoid these long-term drawbacks if ministries, regulators, and public utilities introduce some changes to the IPP model.

As a starting point, finance ministries should develop an "IPP liability indicator" to calculate the offtaker's outstanding liabilities as a function of the nation's GDP. Such a mechanism would allow finance officials to closely monitor their total exposure under alternative scenarios, to define the circumstances under which they will back PPAs with sovereign guarantees, and to set deliberate boundaries on future liabilities.

To contain liabilities, GCC authorities should not only allow but encourage IPPs to secure contracts with additional buyers, such as long-term industrial customers. Diversifying a plant's end-users could reduce the magnitude of governmental obligations to IPPs that might one day become stranded assets.

To ensure that the power system operates as efficiently as possible, system planners should shape IPP tenders as components of an integrated system plan. They should consider procuring a diverse range of IPPs not only for base-load service but also for mid-load and peak-load service.

Recognising that IPPs commissioned today might become stranded assets in a future liberalised market, government offtakers should begin now to build clauses into new IPP contracts that give them the right to acquire the IPP in the future for the unamortized value of the developer's investment.

The offtaker would then have the option of taking ownership of the asset and auctioning it to any interested investor at a price appropriate to the new market. Buyout mechanisms would help assure today's investors of their expected return, while ensuring that PPA commitments will not preclude a future liberalised market.

Although changes of this kind will be challenging to execute, they would be well worth the effort. By making adjustments to the prevailing model, GCC governments can continue to rely on private generation as a source of cost-competitive power and as a liberating alternative to the capital-intensive power projects of the past.