Issue No. 2 - 03/2009

KEY ISSUES ON NEGOTIATING IPP CONTRACTS IN PAKISTAN
by: Kamalul Ariffin Othman (Direct Line: +603 2118 5160) and Mohd Farizal Farhan Abd Ghafar

Mr Kamalul was entrusted with managing TNB's overseas subsidiary Liberty Power Limited (LPL), an IPP in Pakistan from the year 1998 to 2001.

Introduction
The year 2008 saw a dreadful economic slowdown and financial crisis that wiped almost half of the value of the major indices around the world, caused major financial institutions to collapse. Despite all this, we can still see growth of population and rapid urbanization, leading to an intensive demand for utilities in Pakistan. Power shortage had been one of the chronic problems hampering Pakistan’s socio-economic growth. Once upon a time, the problem had gotten so severe that power supply fell short of demand by almost 2000 MW during peak load hours. There were many forced routine interruptions in the supply of electricity during peak hours resulting in load shedding. The unreliable power supply shattered the industrial progress. It is estimated that Pakistan needs to keep increasing its power supply by an annual rate of about 10% to meet demand.

As a result, the Pakistani government has been focusing on policy measures aimed at massive resource mobilization for investment in the power/energy sector. Before privatization, the huge capital requirement to fund such projects for energy was unfavorable to Government’s financial balance sheet. Therefore, the Government took a bold initiative to encourage private sector investment in infrastructure development, in the power sector introducing the Independent Power Producers (IPP). Below are a few key tips on Negotiating IPP Contracts in Pakistan.


ISSUE NO 1 – KNOW THE KEY PLAYERS
Below is a non-exhaustive list of the players, which have significant control over specified areas in the power sector. Get to know them.

The World-Renowned Companies
Currently, there are sixteen Independent Power Producers (IPPs) operating in the country including Southern Electric Power Company, Hub Power, Liberty Power, UCH Power, and Japan Power Generation.

Ministry of Water & Power
The Ministry of Water and Power, besides all policy matters relating to development of these two resources, performs certain specific functions, such as carrying out strategic and financial planning for the long-term master plans in public and private sector. The long-term power sector projects submitted by Pakistan Water and Power Development Authority (WAPDA) and its allied corporations are being scrutinized in the Ministry for its technical and financial viability. Similarly private sector projects in power sector are being processed by the Private Power & Infrastructure Board (PPIB) in close supervision of the Ministry, which sets the policy guidelines for approval of private projects. The Ministry oversees every five-year plans and the Annual Development Programme (ADP) in Water and Power sector. The Ministry of Water and Power also monitors activities in the fields of power generation, transmission and distribution and performs supervisory and advisory role for smooth operation of power sector.

National Electric Power Regulatory Authority (NEPRA)
NEPRA was setup to regulate the power sector in Pakistan and balance the interests of consumers and power sector companies. So far, there has been extensive development of the regulatory regime for the power sector to increase its reliability and efficiency in its operations. NEPRA grants licenses to all generation, transmission and distribution companies wanting to operate in Pakistan subject to certain rules & regulations.

Private Power and Infrastructure Board (PPIB)
PPIB acts as a one-stop shop for investors interested in entering the market, and helps companies and provides support to negotiate power purchasing agreements and obtain licenses. PPIB also assists the NEPRA in determining and approving tariff for new private power projects. The Policy for Power Generation Projects 2002 confirms that electricity will be purchased and tariffs will be set through a process called international competitive bidding.

Pakistan Water and Power Development Authority (WAPDA)
WAPDA implements infrastructure projects for the generation, transmission and distribution of electricity for Pakistan. The state-owned giant has been divided into 14 new companies, which have been whipped into shape with the placement of experienced private sector personnel in top management positions. WAPDA is guaranteed to purchase electricity at a reasonable price from the foreign producer regardless of demand.

Alternative Energy Development Board (AEDB)
Alternative Energy Development Board (AEDB) has been established to promote all environmental friendly alternative / renewable energy resources that have not been developed in Pakistan mainly due to the absence of a high level national body. Since its inception the most important accomplishment of AEDB has been the creation of awareness amongst decision makers regarding the importance of utilizing resources in the country.

ISSUE NO 2 – DON’T BE TOO EXCITED

Availability of Government’s Guarantees 

Government guarantees the performance obligations of its entities such as the power purchaser, and the provinces. Government also provides protection to sponsors and lenders in case of termination of the project.

Predictable Multi-Year & Long-Term Tariff 

Typically, a long-term tariff of 25 – 30 years is contracted with the power purchaser. The IPPs, thus, are not subjected to market risk for their output. The projects are expected to earn an attractive / competitive and stable return on investment.

Standardized Security Package

Standardized and tested agreements – namely, the Implementation Agreement (IA), the Power Purchase Agreement (PPA), the Fuel Supply Agreement (FSA), etc. – are available upfront.

Pass-through of Fuel Cost and Additional Taxation 

Any variation in price of fuel is to be passed on to the power purchaser. Similarly, any additional taxation over and above the Tariff assumptions is liable to be passed on to the power purchaser. 

Income Tax Exemption

Exemption from income tax, including turnover rate tax and withholding tax on import, is available to private power generation projects.

Risk Coverage for Exchange Rate Variation

To cover the exchange rate variations risk, the various tariff components are indexed for variation in the Pakistani Rupee and US$ exchange rates.

Protection against change in Duties & Taxes and Political Risks 

Government guarantees protection against any change in duties and taxes, and against specified “political risks”.

Source: Private Power and Infrastructure Board

When we look at the table above, it sounded like a plan that is “bullet proof”.  These features are designed to attract and protect investors.

However, we should not take these policies for granted. Before entering into the market as an IPP, we should always ask: “What’s the catch?”

The following points may be useful:

  • Don’t be fooled by just one source – gather information from different sources and cross-refer to all of them to make sure that they match. Media X might say that political situation in Pakistan is unstable while Media Y says the opposite. Don’t ask a barber if you need a haircut… research, cross-reference, identify the motives and decide yourself!

  • What happens when the period for such incentives has lapsed? What happens when the long term tariff agreed with the power purchasers lapsed after 30 years, will it sky-rocket, or plummet down making it unfavorable for you to operate and forcing you to sell out? Whether privatized or state dominant, the power sector is always a major concern of a country. You may have to undergo the same hassle to start a new project, facing more barriers to entry by that time since competition will be fiercer.

  • No matter how standard agreements can be, always recheck, and renegotiate! There is always a possibility of a “computer error” or “human exploitation lured by greed” in these standard forms of agreements. There is never any harm in negotiating to fit the needs of the relevant parties. If you don’t bargain you may lose your chance to gain.

  • Get updated on the passage of new legislation, regulation and even policies. It may affect your interests such as of price variation in fuel, as well as variation in tariffs, exchange rates, duties and taxation.

  • Appoint relevant experts for almost everything from the start, whether in respect of management, financial, legal or technical in order to prevent difficult complexity at a later date. They are the key persons to point out the new ideas and bad loopholes that can be found in the project. No business will be successful without sufficient manpower.

ISSUE NO 3 – GUARANTEE OF RAW MATERIALS
It is no doubt that the above policy of the government is quite good. If new companies were to do more here in Pakistan, there are a few things that we must make sure before entering into contracts as an IPP in Pakistan. Perhaps it needs some fine-tuning in some areas. Every IPP, whether existing or potential, has to know that the challenge is the issue of the availability of natural gas and not to mention oil. Projects like IPP will have a life span of over an average of 20 years. It is imperative that we ensure the supply of raw material will continue without too much disruption. Currently Pakistan is not utilizing their natural gas resources as fuel for generation of power as oil still forms a big part of the power industry. Besides natural gas, Pakistan currently holds 0.3% of world’s coal reserves but its production rate is ultimately very low. Having a secured supply of these fuels with the right price, whether through exploitation of resources in Pakistan or through imports, should be a high priority before one enters into the market. Nobody will want to set up shop if it doesn’t have access to supply of raw materials.

ISSUE NO 4 – CONTINUITY
There is no doubt that continuity in government policy and the creation of investor friendly environment are essential for any company wishing to establish themselves as an IPP weather in Pakistan or any other part of the world. Ashraf Tumbi, CEO of one of Pakistan's first and largest Independent Power Plants called HUBCO, said:

“I would say that this applies to the power sector more than to any other sector in the economy. This is because by default, when you are talking about power projects, they tend to have long gestation periods. Construction can also take 3 or 4 years depending on the type of fuel involved. The agreements for these projects range anywhere from 20-30 years, so when people come into the power sector, they have to see continuity in policy. They must know that whatever they are doing today, will last for at least the period of the commercial debt for example. Usually this is also for a 13-14 year period and is not the case with other projects. In other projects they often take about a year to set up and maybe in 5-6 years they are done with it. So this is why in my view, consistent policy is even more important in the power sector.”

ISSUE NO 5 - WATCH OUT FOR INEFFICIENCIES
Pakistan has not yet resolved its problems of inefficiencies at many levels. Each year, a big portion of electricity produced in Pakistan is lost as result of load shedding. On-line transmission losses are estimated to be as high as 30% due to theft as well as the wear and tear of the distribution system. In addition, some transmission wires are made of steel, instead of copper because of the steel plants’ close proximity to power plants and the cheaper price of steel. Steel wires are considered poor quality in terms of international standards because of its lower conductivity. Therefore, actual loss of power is higher when using steel wires than when copper wire is used. Not only that, theft also occurs to most neutral lines. These losses will affect the profitability of an IPP, especially if one is at its starting point when high fixed cost is involved.

ISSUE NO 6 – ENVIRONMENT
Environmental problems are one of the major concerns in the power sector since most of its generation plants are powered by oil. Few years ago, a United Nations study noted that the "concept of waste recycling, treatment, and disposal” does not exist in the industrial sector in Pakistan. Even the highly polluted wastes are being discharged irrationally into water bodies, on soil and in the air. Not only that, generation of power will undoubtedly heat up the environment. Although things are gradually changing, industrial waste treatment systems are still insufficient in the country. Some that exist in a few industries, either technically do not meet the requirement standards or they are out of use or are non-operational. With little national government policies on environmental controls, the industries are able to dispose of the waste the cheapest way possible, namely by dumping. If we are to negotiate to be an IPP in Pakistan, how do we go about reducing or preventing such pollution from getting worse? The issue of corporate social responsibility should not be neglected. Also, in negotiating contracts of IPP in Pakistan, it is a good tip to ask: To what extent is the financial impact on IPP if the Government increases the environmental cost in the investment equation, whether imposed as part of the agreement or license or otherwise?

ISSUE NO 7 – PERCEPTION ON CORRUPTION
Every year, Transparency International publishes an annual Corruption Perceptions Index (CPI) listing the order of the countries of the world according to "the degree to which corruption is perceived to exist among public officials and politicians". Corruption is defined as "the abuse of entrusted power for private gain". A higher score means less (perceived) corruption. According to the index, Pakistan stands at number 134 with a CPI score of only 2.5 over 10. This score is worse than countries that are well known for having high corruption rates such as Argentina, Nigeria, Libya, Uganda and Peru. Based on this perception, it is not an intelligent idea to neglect the high possibility of incurring higher investment costs as a result of the “need to bribe” for IPP projects.

Therefore, in reality, we have to take the issue of corruption in reality with reference to perception since contracts and licenses in certain industries including power, oil & gas can only be obtained through the exercise of power by the government of Pakistan.

ISSUE NO 8 – STABILITY OF THE PAKISTANI GOVERNMENT
This is the number one factor that will unquestionably affect all the other issues above, apart from cost. Political instability can cause a change of government and perhaps change of its policies and regulations including all those favorable policies above. The power industry requires high capital and long gestation period. Nobody wants to lose the capital and resources that they have put in before they can make a profit. Our recommendation would be: “The assumption of government protection should only be accepted if a reasonable man thinks that the policies in respect of IPPs should stay for the minimum period of their contracts.”

Table of Facts
Below is a summary of facts, comparing the different types of fuel that are mainly used in generating power in Pakistan. The list does not include other renewable sources and nuclear power as they contribute to only a small portion (2%) of the total power generated in Pakistan.


Sources: CIA World Factbook 2008 * 
BP Statistical Review of World Energy June 2007**
http://www.nytimes.com/ads/global/pakistan/

CONCLUSION
In short, there are wide range of issues that we must identify before engaging and negotiating for IPP contracts in Pakistan. The above issues are obviously not exhaustive.  It is worth noting that the two biggest issues in negotiating IPP contracts in Pakistan are cost and stability of the Government. Its incentives and intriguing policies that are investor friendly may not be worth a penny if it cannot maintain peace and security.

Due to the major concern of the Government regarding pollution in the country, it may be an excellent option to explore the use of nuclear power or other renewable sources such as wind, solar, bio-mass and fuel cells which may be cheaper and less polluting in the long run. Furthermore, hydro power contributes one third of the electricity generation in Pakistan and the fact that it currently generates “only 6,595 MW out of its identified potential of 46,000 MW” should not be neglected by every IPP who wants to profit and participate in the power sector to provide adequate supply of electricity to the Pakistani population.

 

    IN THIS ISSUE

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MASTER CLASS CONFERENCE ON ‘MERGERS & ACQUISITION’ INTERNATIONAL BEST PRACTICES’
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KEY ISSUES ON NEGOTIATING IPP CONTRACTS IN
PAKISTAN

AZMI & ASSOCIATES OPENS UP A BRANCH OFFICE IN JOHOR
BAHRU

MALAYSIA INVITES INTERNATIONAL LEGAL FIRMS TO SET UP SHOP
IN KUALA LUMPUR

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NEWS HIGHLIGHTS

January 2009

Asia Pacific Legal 500 Award of the Year 2008:
Mr Azmi Mohd Ali, Senior Partner of Azmi & Associates, is identified
as one of the leading Corporate / M&A lawyers
in Malaysia for the year 2008.

January 2009
Azmi & Associates welcomes Tuan Haji Idrus Ismail, who joins us as a senior lawyer to the Firm's Islamic Banking & Finance Practice Group.

December 2008

Asian Legal Business magazine singles out Azmi & Associates as one of the top 30 fastest-growing law firms in Asia for 2008 - the only Malaysian law firm in the list.

 

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