Investors across the world look for policy consistency before making any investment decisions, especially in the context of FDI. In Pakistan, unfortunately, there have been far too many instances of policy revision because of regime change. The government and the courts need to review the policy decisions and revisions taken in the past few decades and their impact on investor confidence and risk premium for future investment.
Recent renegotiations with the IPPs (1994/2002 and wind) is a victory for the incumbents; but the process must be made transparent and dispel perceptions of coercive actions. The fiasco of 1998-99 must not be repeated. And it seems that the negotiations are taking place in a far different tone today than the 1998s.
A similar exercise back then had caused tremendous harm to the power sector. In late 90s, negotiations were a one-man show and resulted in political victimization. Projects that came in during PPP tenure were forcibly re-negotiated by PML-N government. Meetings were called in wee-hours and no paper trail was maintained for the settlement sought.
This of course had a long-lasting impact. No western companies invested under 1994 policy or participated in the power sector again. Some say that a few local companies that had invested under 2002 policies did not show any interest in 2015 policies – perhaps due to the buildup of circular debt.
With every subsequent policy, risk premium charged by the investors increased as well. In 1994, ROE was dollar-based and set at 15 percent – which was reduced to 12 percent in 1998-99 negotiations. In 2002, local players invested at 15 percent ROE indexed to dollar. In 2015, the ROE went up to 17 percent. Commercial borrowing from lenders under the latest policy was also at expensive rates, in addition to steep cost of insurance built-in to these projects (there were other changes in each policy; but for simplicity are not mentioned here).
ROE is based on the risk premium added to the cost of capital, and thus, is linked to interest rates. In 1990s, Libor averaged at 5.8 percent, and ROE was determined based on risks to the sector and the country risk. In 2000s, average Libor was down to 3.5 percent while in 2010s, average Libor rate stood at 1.3 percent.
Based on trajectory of the base rate (Libor), ROEs on subsequent projects should have fallen by 2 percent in each policy, assuming no change in other risks. This means that the ROE of 2002 policy should have been set at 13 percent, and under 2015 policy should have been set at 11 percent. But the returns are moving in the opposite direction. This implies that the country risk charged was significantly higher in subsequent policies.
One reason is of project timing. In all these cases, the then respective regime waited for load shedding to grow before commencing new projects. The desperation of authorities increases the risk premium. By the time the third PML-N government came to power, circular debt had already become a visible issue. The risk premium is added on to the systemic risk in the sector created by growing circular debt. Investors also do not forget to add the risk premium of potential renegotiations in the future based on past experiences of the same.
Having said that, the negotiations this time are less coercive and methodological. Unlike 90s, first a technical report was prepared by a committee headed by M. Ali, a career investment banker with in-depth understanding of the sector. In contrast, renegotiations of 1990s were at the behest of one person’s whims. The report on IPPs prepared by M. Ali and team were scrutinized by both the media and IPPs – and based on those observations, Baber Yaqoob and team deliberated with the IPPs.
Furthermore, Libor is low and is likely to remain low going forward. Hence, lower ROE makes sense. The country’s security risk now is much lower than what it was in 2015. The question is how to move forward. Background discussions indicate that the government plans on a competitive bidding process in future.
Some say that future projects will not come below 20 percent under competitive bidding. This may be right for the time being, but eventually rates will come down. Government should work on renewables now as cost has come down significantly due to technological advancement. And it should plan now rather springing into action when desperation kicks in due to load shedding after 5-7 years. Lastly, resolution of circular debt is imperative for any meaningful risk reduction in the long term.