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Risks of Renegotiating IPP Contracts in Pakistan

The government is under pressure to eliminate or renegotiate IPP contracts amid skyrocketing electricity bills, creating yet another panic situation for the government. PMLN government has a history of making hasty decisions.

 

First, they promised dollarised 30% ROE to power plants in their previous tenure, which is now biting everyone. Now, they are looking for ways to evade those promised capacity payments, which is again going to have long lasting adverse repercussions.

 

There are calls to renegotiate contracts with IPPs; this is the worst thing they can do, i.e. back out of a sovereign commitment. At a time when this economy needs investments, we are going to send out a message saying, ‘please don’t trust us, we can hurt your investment anytime.’

 

I believe the government understands this, which is why there is now a proposal to make upfront capacity payments of PKR 4 trillion to the IPPs and end those contracts. While this can certainly generate savings by lowering the cost of capital from expensive dollarised ROE to cheaper PKR domestic interest rate, I believe there is a serious strategic consideration.

 

What will happen to the electricity supply? Once contracts end, IPPs shall be under no commitment to generate power. They should even be able to sell those plants. Despite economic cycles, the economy has been growing in the long run and hence electricity demand. As a result, we can enter another phase of deficit in the future. Even if the IPPs are required to keep operating under the take-and-pay model, there is no recourse except legal battle if they don’t deliver on their commitment.

 

For those concerned about the source of financing, capacity payment includes both equity and debt components (unless there is some misunderstanding and all 4 trillion pertain to equity). Assuming a 25-75% debt-equity combination, the government roughly needs to borrow an additional PKR 1 trillion which is the equity part. Debt part is already borrowed and just needs to be refinanced. Nevertheless, the equity part will most likely be funded through OMO injection (SBP’s printing machine) as the fiscal deficit is way too high to leave anything for anyone else.

 

I used to write aggressively against this power policy back in the day. Promising 30% dollarized ROE was unfair; nonetheless, the government should not back out of its commitment today. Upfront capacity payment does seem like a viable solution; however, the policy makers must keep future demand supply in mind before making any decision. The government should also consider fixing dollar indexation of local IPPs with the actual dollar cost of the project.

 

One key learning from this episode of IPPs is that capital flows where there is profit. Pakistan needs such profitable policies in the export related sectors. I have been saying repeatedly that our economic crises are always external and not fiscal. Let the private sector make money and generate dollars for the economy.

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