Pakistan’s Energy Crisis Has Become A National Security Issue

Pakistan’s Energy Crisis Has Become A National Security Issue
Pakistan’s flawed energy policies lie at the core of the recent economic crises and rising circular debt.

Former finance minister Miftah Ismail stated  on Sunday that the incumbent government's decision to raise the per unit electricity price by Rs1.95 came in light of the circular debt being at its highest in the country's history, saying the masses will be deprived of another Rs200bn because of the decision. "We had left the circular debt at Rs1,036bn, which included power losses and bank's loan both, and now it has crossed the mark of Rs2,400 billion." Ismail said.

According to an earlier report, the total circular debt increased by Rs538bn during the fiscal year 2019-20 at a rate of about Rs45 per month. During the July-November 2019-20 period, circular debt increased by Rs179bn at a rate of Rs36bn per month, while it slightly reduced to Rs156bn during July-November 2020-21 at a rate of Rs31.2bn per month. It should be recalled that it was in July 2013that the then PMLN government had cleared the circular debt of Rs480bn. By the time, the PMLN government completed its tenure, it had again crossed Rs1 trillion.

Why does the circular debt keep rising despite periodic settlements? A major reason for the chronic and growing circular debt problem isthe size of the guaranteed capacity payments or fixed costs paid to the Independent Power Plans (IPPs). To understand this issue, it is important to understand the historic context of what led Pakistan to outsource power generation to the IPPs.

Until the mid-1980s, Pakistan’s energy needs were met by the Water and Power Development Authority (WAPDA) and Karachi Electric Supply Company (KESC), the two public sector organizations responsible for the generation, transmission, and distribution of electricity. Both were faring quite well. Electricity was producedprimarily through hydropower projects, keeping the production cost minimal. Since the cost of production and demand were low, so inevitably were the subsidies in absolute terms.

By the mid-1980s, increasing demand for electricity and WAPDA’s inability to keep pace with it began to result in energy shortages and load shedding, apparently because the government failed to invest in power generation. Entering the 1990s, Pakistan was planning to increase its existing generation capacity for power production. However, instead of increasing public investments in energy, the World Bank encouraged the Pakistani government to privatize the sector before increasing capacity. In 1994, Pakistan announced its privatization policy, and since then, many private sector power projects have been installed. Despite this, however, the country faces chronic shortages and increasing tariffs.

The power policy viz-a-viz the independent power plants (IPP) was against the very spirit of free market economics as the IPPs were guaranteed a rate of return for putting in a rather small portion of its own equity while major risks were assumed by the government and 70-75 per cent of the investments were actually financed by the bank loans. The first big step in this direction was the Hub Power Project (or Hubco), a 1,292MW, $1.6-billion thermal project that was actively supported by the World Bank. It was the beginning of a strategic blunder that was to haunt Pakistan for decades and continues to do so. This policy was continued by the successive governments and though adding thousands of megawatts to the electricity generation capacity, also made Pakistan hugely dependent on thecostly sources, that is, thermal power, especially on imported oil and coal.

The terms on which investors were invited to set up generation capacity (under the 1994 Power Policy) in the country were some of the most generous in the world according to a study done by two Pakistani economists and published by the London School of Economics (LSE). The paper entitled, Privatization in the land of believers: the political economy of privatization in Pakistan, was authored by Dr Kamal Munir and Dr Natalya Naqvi of the University of Cambridge and the London School of Economics respectively. They pointed out that the policy was built on a cost-plus-return basis in US dollar terms. Investors were to be provided a US dollar-based internal rate of return of 15 to 18 per cent per year over the 25 to 30-year-period of the power purchase agreement after covering for operational costs. This was further backed by sovereign guarantees from the Government of Pakistan. The Independent Power Producers (IPPs) were to be paid every month in two parts, i.e., a ‘capacity payment’ and an ‘energy payment’. The ‘capacity payment’ reimbursed the IPP for all the fixed costs of the power plant, including debt servicing (which at an allowance of 80:20 debt-equity ratio proved to be very high) and provided the investor’s equity return on top. These payments were to be made irrespective of whether or not the IPP was asked to produce electricity. The ‘energy payment’ reimbursed the IPP for all variable costs of production, e.g., fuel costs, regardless of the type of fuel employed and its market price. All payments were indexed (if relevant) to the USD/PKR exchange rate and inflation (local or foreign) changes.

The highly generous deals that the government offered (in the 1990s)to investors meant that for every hypothetical but typical 100 MW thermal (oil-fired) power plant in the private sector, the government would end up spending US $21.42 million more than it would in the public sector over the life of the power project according to the LSE study.

The bulk of this investment was in power plants that ran on imported fuel oil, in part because the low oil prices of the 1990s made fuel oil an inexpensive option. These projects contributed to a substantial transformation of Pakistan’s power generation mix. Hydropower’s share of installed generation capacity fell from around 67 percent in 1985 to 27 percent in 2017, while oil’s share was 26 percent in 2017. The dramatic increase in oil prices in the 2000s (reaching a high of $147 per barrel in 2008) caused Pakistan’s power generation costs to skyrocket. Pakistan’s reliance on fuel oil for power generation contributed to the liquidity crisis in the country’s power sector known as circular debt, which in turn contributed to the country’s frequent power outages.

The next phase of expansion in the power generation capacity started in 2015 under the China Pakistan Economic Corridor (CPEC) program. Power sector projects are a large component of CPEC. Generation and transmission projects account for 7 of the 11 CPEC projects completed and 6 of the 11 CPEC projects under construction at the end of 2018. In addition, the 15 power sector projects that comprise the CPEC energy priority projects—those initially scheduled for completion by 2020 represent 55 percent of the value of all the projects on the government of Pakistan’s CPEC website with an estimated cost listed ($20.9 billion out of $38.6 billion).

Three-quarters of the new generation capacity to be added by the CPEC power sector projects is from coal-fired power plants (see Table). Indeed, the government of Pakistan expects the CPEC power plants to contribute to an expansion of coal’s share in Pakistan’s power generation mix from 3 percent on June 30, 2017, to 20 percent on June 30, 2025.

Between 2016 and 2020, nine CPEC power plants with a total installed capacity of 5,218 Mega Watts (MW) were completed at a total cost of $7.8 billion. 75% of this additional capacity came from the power plants using imported coal as fuel. Another nine power plants are under construction with a planned addition of 6,991 MW to the power generation capacity at an estimated total cost of $12.7bn.

Over the past 20 years Pakistan did not take interest in hydro power generation, pushing instead for thermal power plants which caused the share of hydro power to decline in national electricity generation. Therefore, hydro contribution in total electricity generation has reduced from 45 percent in 1990 to 25 percent in 2020, with much of the remaining 75 percent being thermal power. This has increased the overall cost of power generation in Pakistan because of relying more on non-renewable resources.

Three things were noticeable about Pakistan’s energy policy about the independent power plants since the 1990s. First, though it offered highly generous returns, it provided no incentives to make the plant design efficient. For example, Huaneng Shandong Ruyi Company that built the imported coal power plant of 1,320 MW capacity  located at Qadirabad, Sahiwal, was guaranteed a return of equity of 27.2% per the company’s agreement of March 31, 2015 signed with National Electric Power Regulatory Authority. In fact, since the government paid for all operational costs, many thermal IPPs understated their efficiency. Second, the policy was fuel blind, which meant investors were free to set up furnace oil or imported coal based thermal IPPs with the government still covering the cost of the fuel. Finally, with the government guaranteeing returns to investors, there was effectively no competition in the market.

Recently, the government has signed memorandums of understanding (MOUs) with some IPPs. The MoUs provide for changes in the terms of the existing power purchase agreements that will reduce the size of the guaranteed capacity payments or fixed costs paid to the IPPs, a major source of accumulation of the circular debt. The government is expecting savings of Rs850bn over a period of 10 years, following the modifications in PPAs. However, this scheme covers the old IPPs which were set up in the 1990s and 2000s and had consented to the alterations proposed in their power purchase deals with the government. In recent years, the major build-up in the circular debt has been caused by capacity payments to large power projects(mainly under CPEC) set up since 2015. So far, no progress has been made to get the generous terms granted to these companies under the power purchase agreements (PPAs).

Pakistan’s flawed energy policy lies at the core of its recurring crises. The policy attracted investments only in the thermal power as it offered a quick and almost riskless way to make money due to the generous terms offered to the investors. The most difficult and challenging part, that is, managing the distribution, was not privatised.

As Dr Kamal Munir of Cambridge University wrote in a paper, “the most difficult tasks in the power value chain are more or less all in the public sector’s domain at the moment, i.e., bill collection, and transmission and distribution (T&D), while the IPPs have conveniently kept the “easy” bit, i.e., generation.”

As per the figures available, since 2007 Pakistan has been haemorrhaging 2-4% of its GDP to the prevalent energy crisis. Energy crisis, as discussed above, not corruption of a few political leaders, lies at the core of our recent economic crises. Pakistan’s energy  crisis must be tackled at both operating and strategic level as it has imposed unjustifiable burden on the poor and the middle class, is a source of international competitive disadvantage for our industry, is a significant contributor to the debt burden and has, in fact, become a national security issue. Unfortunately, all governments have failed to understand the core issues. It is time, we consult professional energy and public finance economists and form a commission to study the energy crisis and sector in a comprehensive manner and come up with policy recommendations aimed at providing a long term and sustainable solution. Because clearly, both the bureaucrats and the conventional wisdom offered by the world and the IMF have failed to provide a sustainable solution.

Yousuf Nazar is a former investment manager. He has published several articles on Pakistan’s politics and economy. He is the author of a book, “Balkanisation and Political Economy of Pakistan.”