Monday, July 18, 2011

Moral Hazard in Power Sector

I have blogged earlier here and here about how the possibility of contract renegotiations on competitively bid tender conditions has generated a moral hazard among infrastructure developers. Secure in the belief that the re-negotiation window is always open, they bid aggressively to win the bid.

The latest evidence of this moral hazard comes from Reliance's Coastal Andhra Power Ltd. (CAPL) stopping work at its Krishnapatnam Ultra Mega Power Project due to increase in the cost of its Indonesian coal. The developer claims that the new Indonesian Coal Price Regulation would push up the coal price and therefore cost of generation, imperil its cash flow and its ability to repay lenders.

As the Businessline writes, this development is surprising since the UMPP PPAs exclude fuel from the force majeure provisions, being specifically mentioned under Clause (a) of Article 12.4 of the PPA that lists out the 'Force Majeure Exclusions'. Further, even the 'Non-natural Force Majeure events' specified in the PPA does not include actions by a foreign government.

In other words, when the tender was called and agreement negotiated, it was clearly known to all parties that the fuel risk was solely vested with the developer. CAPL had bid aggressively in the tariff-based competitive bidding process, quoting a levelised tariff of Rs 2.33 per unit. Reliance Power has won three UMPPs so far. It is therefore, on every measure of reasonableness and contractual obligations, unacceptable for CAPL to stop work citing fuel price risks. Given precedents elsewhere by the same firm and others, this is the predictable path towards a request for re-negotiations on the terms of the contract.

It reflects a lack of professionalism, even questionable intent, on the part of the developer to have entered into the PPA without having hedged for fuel price risks. In the circumstances, the government should issue notice and get the developer to comply with its contractual commitments failing which the PPA should be terminated and the firm black-listed. It is the least that can be done to mitigate the moral hazard that has been unlreashed by frequent requests for re-negotiations.

Most importantly, the final outcome from the CAPL example could well determine the fate of tariff-based competitive bidding in India. The critical parameter in all the Case I bids are the tariffs discovered in the competitive bidding process. All bidders offer their quotes based on clearly known assumptions, of which fuel price risk being borne by bidder is the most fundamental. It is outright dishonest for any successful bidder to backtrack from the project citing fuel price increases.

Therefore, if the CERC buckles on this, it will inevitably open the floodgates for similar requests and destroy the market for tariff-based competitive bidding in the country.

Update 1 (28/7/2011)

Another example of contract renegotiations is the decision by Reliance Power Transmission's Talcher-II Transmission Company to issue the force majeure notice to electricity distribution utilities in Andhra Pradesh, Karnataka, Kerala, Tamil Nadu and Orissa. The Businessline reports that the company has cited unforeseen delays in clearances for a key transmission link being executed by it as one of the reasons for serving the notice. It has not started work on the Talcher-II transmission system that was to evacuate electricity from generation stations in the eastern region to mainly the southern States. The link was to be up by October 2012.

1 comment:

Anonymous said...

I think these kinds of contract renegotiations and relaxations are very common in India. There are numerous other cases in Andhra Pradesh itself, most obviously in the irrigation projects, where the contractors have renegotiated the contract terms or cost estimates less than half-way thru the execution. And it should hardly be surprising considering that most of the politicians have proxy interests in the companies and the pliable bureaucracy is hand in glove to the ruling class interests. The existence of perfect competition or something close to it is a myth in Indian markets. Don't think 'moral hazard' is an accurate description of the malaise. Conversely, if the contract enforecement and strict quality control measures can be brought about, the bidding process and the players might appear more like perfect competition.