The issues with IPPs

By Khairie Hisyam

The shadowy terms given to the early IPPs, as well as the lack of an open tender process, meant transparency was sorely lacking. This and other issues surrounding the early IPPs were addressed to some extent through changes in power purchase agreements with later IPPs as well as proposed reforms, but are they sufficient?

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The emergence of the first five independent power producers (IPPs), dubbed the first generation, was fast. With a combined capacity of 4,157 megawatt (MW) against then-existing capacity of roughly 6,000 MW, Malaysia went from potential power shortage to power glut rapidly.

By January 1997, Peninsular Malaysia reportedly had nearly 50% in surplus capacity.

At the heart of the problem was poor planning on the Economic Planning Unit (EPU)’s part, which was responsible for issuing IPP licences.

In 1996 the Far Eastern Economic Review reported that government officials have privately admitted too many IPP licences were handed out too quickly. Additionally national utility Tenaga Nasional Bhd (TNB) also continued adding to its own capacity, reportedly concerned that some IPPs would be late in plugging into the grid.

“Compounding these problems on the government side was the fact that the favourable terms in the contracts offered by Tenaga drove strong investor interest, while limiting the incentives to conduct due diligence regarding the actual supply-demand situation in the country,” commented a 2005 Stanford University paper titled ‘The IPP Investment Experience in Malaysia’ by researcher Jeff Rector.

Lacking transparency

With the number of IPP licences issued directly, the biggest issue was transparency.

As the power purchase agreements (PPAs) are classified under the Official Secrets Act 1972, it is nearly impossible to discern whether the deals were fair from the consumer perspective without an open tender process that would have at least added some pressure for efficiency and lowest-possible cost.

Based on former TNB executive chairman Ani Arope’s disclosures about the first-generation IPPs, it is likely that most, if not all, were not.

According to the Association of Water and Energy Research Malaysia (AWER), information provided by TNB shows that IPPs, up to the third generation, averaged double-digit in internal rate of return (IRR), though the figure is declining from the first generation.

In any event, it was only in 2005 that things changed in terms of licence issuance. In that year the government announced the 10-year transformation programme for government-linked companies (GLCs), which among others declared that all IPP licences would be awarded through open tender to ensure the best price for electricity generation.

However by this time IPPs were well into the third generation and, in 2004, TNB reportedly had 40% in surplus capacity — the cost of which was ultimately borne by consumers through capacity charges paid by TNB.

Other issues on the early PPAs

Transparency aside, the primary reasoning for introducing IPPs into the nation was to meet surging demand for electricity brought about by Malaysia’s rapid economic growth in the 1980s.

The idea was to bring private-sector efficiency into a state-monopolised sector. However the long PPA tenures, which in the first generation effectively guaranteed a certain margin of earning come rain or shine, insulated IPPs from constantly changing market conditions.

This effectively removed private-sector efficiency out of the equation as its driver, market-driven competition, was not a factor, given how the IPP licences were awarded directly.

Essentially, the early IPPs were protected from risk at TNB’s expense, a factor which is normally part and parcel of any business. On the other hand TNB, obliged to cover for any increase in fuel costs, would not be able to pass on higher costs caused by shifting market conditions to consumers without an electricity tariff hike.

A case in point was in August 1998, when TNB posted its largest annual loss at that point of RM3.09 billion. Then-TNB chairman Ahmad Tajuddin Ali was reported as saying that the national utility faced problems in paying IPPs, seeking “deferments and discounts” from them.

While Tajuddin asked IPPs to consider national interest and hinted that IPPs would sink along should their sole buyer TNB go under, no renegotiation took place as explored in the previous part of this series.

In terms of speed, IPPs were no faster than TNB in planting up as the construction process remained the same. Notably TNB, as a sovereign-backed entity, enjoys lower cost of funding compared to IPPs, which reduces overall electricity generation costs compared to IPPs.

In addition, a high threshold of take-or-pay capacity spelt out in the early PPAs meant consumers had to bear the cost of excess capacity that they did not need, evident from the surplus capacity hitting 50% just before the Asian Financial Crisis struck in 1997.

In short, with higher cost of funding IPPs cannot match TNB’s end-price should the national utility had produced all power itself, especially with the unneeded excess capacity brought about by too many IPPs coming in that consumers nonetheless had to pay for.

Therefore in terms of public interest as electricity users, the way IPPs were initially brought into Malaysia raised numerous questions.

Changes through each generation

However, it must be noted that there had been a trend of changes from the first generation of IPPs onwards.

When the second generation of IPPs came into the picture between 1998 and 2001, the most notable change was that their PPAs reportedly allowed for renegotiation in the event of an industry restructuring as opposed to the binding nature of the previous PPAs.

Should no agreement be reached within six months TNB was empowered to terminate the PPA and acquire the project at a pre-determined amount, according to news reports.

This provides room to TNB to either continue with a PPA or terminate it depending on the situation at hand while managing stranded costs issues. Stranded costs refer to existing investments for TNB that would be redundant in a competitive environment.

Another shift was relatively more stringent requirements for the second generation. While the previous generation of IPPs was allowed a combined limit for both scheduled and unscheduled outages, the second generation IPPs were given separate limits for both types of outages and were penalised if unscheduled outages exceeded the limit.

This contrasted with bonus payments that first generation IPPs were eligible for should availability go beyond a specified level.

The second generation PPAs also allowed TNB some leeway in paying capacity charges in the event of an unavoidable incident or force majeure, something that was not provisioned for in the first PPAs.

In short, the second generation PPAs transferred more risk to IPPs and their financial backers while TNB gained some breathing room in terms of force majeure risks.

The third generation of PPAs incorporated a demand risk-sharing mechanism between the national utility and the IPPs as seen in the first of these signed between TNB and SKS Power Sdn Bhd.

Under the agreement SKS Power would share the cost of excess capacity. “Under the demand risk sharing concept, only the portion of capacity payments related to debt service will be guaranteed while the other portion which in essence is the return attributable to shareholders, will be paid upon dispatch,” said a Malaysian Rating Corporation Bhd (MARC) report in 2006.

Under this mechanism, a portion of the capacity payment would be paid to IPPs based on availability and performance while the remainder would only be paid upon despatch by the system operator.

Driving reforms

Against the backdrop of issues concerning the IPP licence issuance process and criticism of an uncompetitive power sector that resulted, MyPower Corporation, a reform unit under the Ministry of Energy, Green Technology and Water (Kettha), was set-up in 2010.

This followed the 2005 commitment, through the government’s 10-year GLC transformation programme, to award all new IPP licences through open tender.

The primary objective of this unit is to review and recommend reform initiatives for the power sector in seeking to ensure that the electricity supply industry is reliable, transparent, efficient and sustainable.

In October 2012, TNB won the first competitive bidding process for the Track One power project, which entails the construction and operation of a 1,071 MW combined cycle power plant in Prai.

Other reform initiatives include the incentive-based regulation (IBR) which improves the transparency of the tariff structure by facilitating regular tariff adjustments that allows TNB to recover cost fluctuations beyond its control such as fuel.

But are these reforms sufficient to put Malaysia on a sustainable long-term energy path?

Yesterday: Malaysia’s other first-generation IPPs

Tomorrow: Dissecting power sector reforms