Wednesday, May 19, 2010

Incentive distortions in financing power projects

Businessline reports of a new trend in financing power projects, wherein power equipment manufacturers, power trading companies, and O&M contractors have been "sweetening their pitch for contracts by offering to contribute equity stakes in upcoming projects". However, despite its obvious attractiveness for both developers and equity investors, this trend opens up several opportunities for conflicts of interest and incentive distortions.

Equity participation becomes attractive for cash-strapped promoters, especially state generation companies (from Maharashtra, Tamil Nadu, and Karnataka), in achieving financial closure. Manufacturers, traders and contractors see equity participation as a backdoor to bagging contracts.

Assuming that promoters' investment decisions, on both capital and technology, are always driven by profit and efficiency maximization, the aforementioned model creates possibilities for incentive distortions that goes against these objectives. Here are three possible such conflicts of interest

1. Equity contributions by manufacturers have the potential to distort equipment and technology specifications (as the equity investing manufacturer tries to influence the bidding process to his advantage), and in the process result in sub-optimal investment decisions. Given the 80:20 debt-to-equity ratios in power projects, manufacturers see a small equity stake as a cheap way to bag massive contracts.

2. Power traders with investments in generators have an incentive to selectively restrict generation/supplies and thereby create artificial shortages, so as to inflate prices.

3. O&M contractors with equity investments have an incentive to get contract provisions incorporated that are not necessarily in the interest of the project.

It is therefore imperative that the Central and State regulatory commissions take appropriate measures to curb such conflicts of interests. But, whatever the precautions incoporated into contract provisions, through regulatory directions, to pre-empt these perverse incentives, it is impossible to fully eliminate them.

No comments: