The Future of IPPs in the GCC
In recent years, countries in the Gulf Cooperation Council (GCC) have increasingly turned to independent power projects (IPPs) and independent water and power projects (IWPPs) as alternatives to government-financed power and cogeneration plants. If projections hold true and IPPs account for 34 percent of regional capacity by 2015, with virtually all of that capacity serving base load, then IPPs will account for nearly 60 percent of regional energy production. To support such an increase, changes in the way that IPPs are structured need to be made to preserve the benefits of the IPP model.
IPPs are a relatively new phenomenon in the GCC. Up until the mid-1990s, power plants in the region were exclusively financed and developed by governments and government-backed corporations. Today, across the GCC, more than two dozen IPPs and IWPPs are now in operation, with a combined installed capacity of 20 gigawatts. IPPs have now almost entirely displaced traditional public power plants as sources for new electricity generation in the GCC. However, rational choices made at the case-by-case project level have left the IPP model vulnerable to long-term aggregate risks, such as accumulated offtaker liabilities, a potential shortfall of plants capable of providing mid- and peak-load service, and the postponement of fully liberalized electricity markets.
The IPP Triumph: Growing Despite the Crunch
The reason IPPs have almost entirely displaced the traditional public power plants for new generation stems from the operating model that IPPs employ and from several distinct advantages it offers to governments. The advantages are an amortization of public expenditures, a competitive cost of power, predictable timing and often faster execution, the establishment of performance benchmarks and the promotion of a favorable business environment. These advantages are fueling a phenomenal growth in IPPs. “Current expansion plans will more than double the region’s IPP and IWPP capacity over the next five years, bringing the privately developed share of aggregate electricity generation to about 34 percent,” said George Sarraf, Partner, Booz & Company.
The basic IPP model is consistent across the region: The amount of power to be sold is stipulated in a power purchase agreement (PPA) at a fixed price, the PPA is guaranteed by a creditworthy offtaker backed by the government, and the price of fuel is fixed by contract. The model eliminates market and fuel risk for the IPP developer, and the remaining risk consists of difficulties the developer might encounter with financing, construction, and operation. “This modest risk profile permits IPP developers to use limited-recourse, high-leverage project financing schemes, with debt ratios averaging 75 percent and reaching as high as 85 percent. Consequently, IPPs have been exposed to the global credit crunch; although there have been recent adjustments to financing terms, they have not fundamentally stopped IPP growth,” said Walid Fayad, Principal, Booz & Company.
The Pitfalls of the IPP Model
However, all progress carries with it inherit risks. The fundamental risk of the IPP model stems not from individual projects but from the long-term aggregate effect of applying the model exclusively. Rational choices at the case-by-case project level can lead to unwanted consequences at the sector level. As IPPs become more familiar in the region, policymakers need to be conscious of the potential limitations to the advantages they provide. Three of these limitations are of particular concern.
The first and most obvious limitation is inherent in the practice of amortizing present investment. GCC nations are tying up increasing shares of GDP in explicit and implicit IPP/IWPP obligations. “In the UAE 0.8 percent of the country’s GDP is tied up in explicit and implicit IPP/IWPP obligations,” said Sarraf. However, accumulating liabilities have a way of taking public institutions by surprise. In the long run, these accumulating commitments can affect not only the cost of capital required by IPP developers and their lenders, but also the credit ratings of the offtakers themselves.
A second long-term risk concerns the fact that IPPs are biased toward providing base-load power, which could ultimately leave system planners struggling to meet daily and seasonal fluctuations in demand. The advantages of IPPs over incumbent plants are likely to be far greater in the mid-load and peak ranges of operation than in the base-load range. The start-stop operation of mid-load and peak-load plants offers greater potential gains from management efficiency than the steady-state operation of base-load plants. “Although best-practice management methods may produce efficiency gains of 2 to 3 percent for base-load plants, they can offer gains as high as 30 percent for mid- and peak-load plants. By concentrating IPP awards in the base-load category, the GCC is foregoing much of the economic gain that IPPs could provide,” said Fayad.
The third risk of IPP dependence is that it can inhibit the natural evolution of the power sector toward increased liberalization. If the current trajectory of IPP investment continues, using the existing model, GCC nations may find within 10 years that a major portion of their generation assets are locked down in long-term PPA contracts. Such a situation would substantially compromise the flexibility of the power system to adapt to market forces.
Making the IPP Model Last
GCC governments can counter and even avoid these long-term drawbacks if ministries, regulators, and public utilities act now to introduce some changes to the IPP model. These changes would be reflected in the regulatory framework and the electricity system plan, as well as in the way IPPs are packaged, tendered, and structured.
These changes consist of introducing IPP liability indicator, encouraging additional buyers, procuring different IPP loads, and building buyout mechanisms.
IPP Liability Indicators
Such a mechanism would allow finance officials to closely monitor their total exposure under alternative scenarios, to define the circumstances under which they will back PPAs with sovereign guarantees, and to set deliberate boundaries on future liabilities. A government may decide that loose boundaries are appropriate, but it should make that decision consciously and not through inertia.
Encouraging Additional Buyers
To contain liabilities, GCC authorities should not only allow but encourage IPPs to secure contracts with additional buyers, such as long-term industrial customers. Diversifying a plant’s end-users could reduce the magnitude of governmental obligations to IPPs that might one day become stranded assets. Governments should empower IPPs to sell excess electricity not just to the network but to other industrial users as well by allowing and regulating “wheeling.”
Procuring Different IPP Loads
To ensure that the power system operates as efficiently as possible, system planners should shape IPP tenders as components of an integrated system plan. They should consider procuring a diverse range of IPPs not only for base-load service but also for mid-load and peak-load service. In some GCC countries, IPP tenders are specified for particular load categories—a practice that should be emulated throughout the region.
Building Buyout Mechanisms
Buyout mechanisms would help assure today’s investors of their expected return, while ensuring that PPA commitments will not preclude a future liberalized market.
The combination of these changes would help ensure that the current IPP model evolves to meet the challenges of a more open market. At some time in the future, regional electricity markets will likely liberalize, tariffs will cover economic costs, and government will remove itself from the business of overseeing and subsidizing power. At that point, IPPs will play the same role they have filled in liberalized power markets elsewhere—markets in which they invest at their own risk and earn returns that are determined not only by their efficiency as developers and operators, but also by the market itself.
Power markets in the region are evolving, and IPPs are assuming too important a role in GCC countries to be treated as anomalous outliers to the power system. Instead, IPPs should be active enablers of market evolution. By making adjustments to the prevailing model, GCC governments will continue to be able to rely on private generation as a source of cost-competitive power and as a liberating alternative to the capital-intensive power projects of the past.