Are IPPs part of our future?

By Khairie Hisyam

Given IPPs’ apparent problem in competing with state-backed entities in competitive bidding for power projects, do they have a place in our electricity generation big picture? KiniBiz examines the paths forward.

____________________________________________________________________

With independent power producers (IPPs) apparently struggling to compete with Tenaga Nasional Berhad (TNB) and 1Malaysia Development Board (1MDB) in competitive bidding for power projects, do we even need IPPs?

In a recent interview with KiniBiz, former TNB executive chairman Ani Arope feels not, arguing that TNB should undertake all new power plants as electricity supply is a matter of national interest.

“For any new plants coming, just give it to TNB to do,” said Ani to KiniBiz. “They keep the price down.”

The call presumes that TNB is able to produce electricity at a lower cost than IPPs, which based on recent competitive bidding results may be true — apart from TNB, only 1MDB has won a competitive bidding process for power projects.

This is primarily due to lower cost of financing in TNB’s case as a sovereign-backed entity and which 1MDB also presumably enjoys given that it is a state investment fund.

At this rate, bar any further direct awards as seen for Track 4A power project, TNB and 1MDB may end up being the only power producers for the nation. It is notable that, since its first power asset acquisition in May 2012, 1MDB had rapidly risen to become the third largest power producer and notably the second largest IPP behind Syed Mokhtar Albukhary’s MMC Corporation.

 

Should TNB do it all?

So can TNB be the sole power producer for Peninsular Malaysia? Power sector observers KiniBiz spoke to feel they can take on the role.

“Financially, technically, (TNB) has the capability,” said one power sector observer.

Taking an example of the Track 4A power project, TNB’s role in the YTL Power-anchored consortium was ownership of the land for the project, according to an Energy Commission (EC) media statement.

Yet TNB can do more — funding would not be an issue given TNB’s strong financial position.

While there had been no official figures released for Track 4A, most estimates place the project to be around the RM3 billion mark. In comparison TNB had RM12.9 billion in cash and cash equivalents as of the second quarter ended February for the current financial year ending August.

Cash aside, TNB also has much room to obtain further financing. According to its latest quarterly results for the second quarter ended February this year (2Q14), TNB had total short-term and long-term borrowings of RM26.47 billion against total equity of RM38.03 billion. This translates into a net gearing ratio of just 0.69.

And herein lies the company’s major edge against other independent power producers (IPPs) — as a sovereign-backed entity, TNB can get loans at lower cost.  This translates into lower electricity generation cost.

“There was a situation last year where IPPs moved to ask government to stop TNB from issuing letters of guarantee,” said Association of Water and Energy Research (AWER) president S. Piarapakaran.

A letter of guarantee essentially assures financing institutions that TNB would take certain risks in a given project. By contrast, IPPs take full financing and pass on the whole risk to the financing institution, said Piarapakaran. “This increases interest rates.”

Correspondingly, following YTL Power’s drop-out from Track 4A, there had been calls for the project to be given directly to TNB.

The case for a sole producer

However, while taking Track 4A would allow TNB to contain its costs to some extent, it would not translate into lower electricity tariffs as the end-tariff is based on the overall costs of power generation spanning TNB’s generation division as well as the IPPs.

Being the only buyer of electricity, undertaking Track 4A means TNB would save in terms of the priced-in profit margin for IPPs should it buy from a third party electricity producer.

However an industry observer doubts whether such savings would be substantial, given that the margins for IPPs have dropped in recent times.

“(The IRR) may be as low as mid-single digit (in percentage) now,” said the industry source, declining to be named. “TNB’s core business is distribution (anyway).”

It is difficult to ascertain how much savings TNB would accrue as the national utility does not break down its costs and only presents the information in an overall manner encompassing generation, transmission and distribution processes.

The natural extension of that line of thought, however, would be that if TNB undertakes the entire power generation activity in the country, its capability of doing so at lower costs would translate into lower electricity tariffs given its cumulative savings across the electricity generation sector.

In such a scenario, TNB — as the sole power producer as well as distributor — would generate power at cost and reap its profit from the distribution side.

As for end-consumers, lower electricity generation costs would likely translate to lower electricity bills.

The other side of the coin, however, is the longstanding criticism that monopolistic markets often lack the drive to pursue maximum efficiency and quality delivery in absence of competitive pressure.

Retaining IPPs

Alternatively, another way forward for the electricity generation sector would be to retain IPPs in-line with the power sector reforms driven forward by the EC.

To do this, however, IPPs should bear more of the risks involved in power projects, argued AWER president S. Piarapakaran.

“It’s a controlled industry with few players, why don’t they themselves take more risks?” said S. Piarapakaran to KiniBiz. “If you only want profit (without the risk), might as well don’t participate.”

Instead of passing on most the project risk to financiers when bidding for power projects, IPPs should shoulder some of the risk involved by committing more equity to bring the financing cost down, added the AWER president.

This would allow IPPs to offer lower tariffs when bidding for power projects. In comparison, the current 9.1% average internal rate of return (IRR) for fourth-generation IPPs is nearly double that seen in some other countries.

“From what I know, (IRRs in other countries are) 5-7%, maybe lower, depending on the competitiveness,” said AWER’s S. Piarapakaran.

Notably, the IRRs in Malaysia is guaranteed whereas in other countries it is not.

However another industry observer raises the question of whether the lower financing cost from this would be substantial enough. “Can they match TNB’s cost?” asked one industry observer.

The Association of Independent Power Producers (Penjana Bebas) declined to be interviewed by KiniBiz. Several IPPs contacted also declined to comment.

In favour of the IPPs’ enhanced competitiveness through lower financing costs would be the establishment of the Single Buyer Department (SB) in September 2012, which ring-fenced the electricity procurement function within TNB.

This levelled the playing field to some extent as, prior to SB’s formation, the procurement function was embedded within TNB’s vertically integrated structure, which was also competing with IPPs to sell electricity generated.

If IPPs are able to truly compete with TNB in terms of electricity generation costs by shouldering more risk themselves, then the competitiveness factor would be present to drive costs down for the end-consumer.

To further spur the competitiveness, fixed capacity take-up in power purchase agreements (PPAs) should also be a thing of the past. Instead, bidding should be the way forward so as to ensure the lowest price possible.

One example is the Australian electricity market, which comprises five trading regions managed by the Australian Energy Market Operator (AEMO), according to the Australian National Electricity Rules.

Among others the Australian electricity market matches demand for electricity with supply from generations in blocks of five-minute periods based on the electricity suppliers’ bid prices. The price is kept under a price cap and the AEMO also imposes a negative floor price, which allows electricity suppliers to pay in order to stay online when the cost is lower than the expense of shutting down and re-starting their plants.

For Malaysia, a possible middle ground would be to set a lower minimum capacity take-up — for example 50% — to secure a certain capacity for the national grid while any take-up of electricity beyond the minimum capacity can be decided through bidding.

A stronger EC needed

In both the scenarios above, however, a strong EC is need as the market regulator.

For TNB to become the sole power producer in Malaysia, the onus would be on the EC to become the check-and-balance factor in ensuring that the monopoly does not dull TNB’s pursuit for maximum efficiency.

This means the commission needs to conduct regular reviews of TNB’s operations and results to keep the national utility on its toes.

On the other hand, the commission’s task would arguably be somewhat greater in the second scenario with IPPs staying in the picture through becoming more competitive.

For one, the EC need to be firmer in pursuing the government’s previously stated commitment to the open tender process in awarding power projects.

“We were informed that after the Track 3B power project award, (industry) players were informed to prepare their bids for the next round (Track 4A),” said AWER president S. Piarapakaran.

However Track 4A was eventually awarded through direct negotiations, with the EC chairman Abdul Razak Abdul Majid seen making an abrupt U-turn from his previous statement that the project would not be awarded that way.

News reports in May previously quoted Abdul Razak as saying the commission had not received any instructions from authorities to engage in direct talks for the project, though he was later quoted as saying he would consider direct negotiations if told to do so.

Following the abrupt U-turn, EC member Mohd Nasir Ahmad resigned due to unhappiness over how the Track 4A power project was awarded. Another member, Abdul Razak’s predecessor Ahmad Tajuddin Ali, was also believed to have resigned for similar reasons.

“EC must be fair as the regulator, they cannot flip-flop (like this because) then people won’t respect (i),” said AWER president S. Piarapakaran, adding that the EC should “practice what it preaches.”

However the chronology of the Track 4A direct award controversy raised questions on whether there was interference that caused the EC to go against its commitment to competitive bidding.

Moving forward the EC would need to be truly independent and firm to carry out its assigned duties as market regulator, either to oversee TNB as the sole electricity producer or to regulate a market with IPPs.

Improving the competitive bidding process

In addition to a stronger EC, the competitive bidding process for power projects can also be improved, said AWER.

“The EC should not set bidding criteria that pushes prices up,” said AWER president S. Piarapakaran to KiniBiz. “One example is land (for the project) — why specify the type of land?”

Instead the commission should let bidders source for whatever land for the project that can bring down their costs and subsequently their offered tariffs, said the AWER president.

He explained that brownfield sites are naturally cheaper to enhance for a new power project as it would have existing facilities and connection to the national grid, although sometimes greenfield sites can be cheaper too.

In addition, the think tank proposes that the commission be more open about the bids submitted for any given power project. This is not yet done, said the AWER president.

“Once everyone submits their bids, I think the EC can just open the envelopes and explain who has submitted what, display all this information in a summary — cost structure, technical details, cost passed to consumers,” said S. Piarapakaran. “I think this is the transparent way.”

But perhaps what stands in the way of all these measures is how politics interferes and the government uses IPPs as a means of distributing patronage. While some moves to move forward in terms of institutionalising tender procedures have succeeded there have been recent setbacks.

Even under the open bidding process, IPPs are a very lucrative business guaranteed almost to make profits and give substantial returns on equity investments even if the internal rate of return had dropped to single digits.

The root of the problem remains so far completely unaddressed.