Wednesday, October 12, 2011

Contract re-negotiations in power sector

I have blogged earlier raising concern about the growing trend of contract re-negotiations in competitively bid out tenders, especially in power sector. If successful bidders renege on their contractual obligations when faced with risks they were supposed to have mitigated but actually did not, what is the sanctity of contracts?

First the Reliance's Coastal Andhra Power Ltd (CAPL) stopped work at its Krishnapatnam Ultra Mega Power Project (UMPP) and served force majeure notice citing higher fuel costs due to the Indonesian government's decision making all coal exports mandatorily at international prices. Now Tata Power is following suit on the same grounds for its Mundra UMPP. If two of the flagship UMPP tenders on private participation in power sector are being revisited on the most fundamental of risks in any power generation project - fuel risk - then it does not speak well about the regulatory/governance environment in the sector.

Equally objectionable is the input cost escalation argument being invoked to demand renegotiations on transmission projects. This is a classic case of failure to mitigate construction risks. The most applling though is the decision by Essar Power Gujarat Ltd, a subsidiary of Essar Energy, to terminate its 25 year PPA to supply 800 MW of power to Gujarat Urja Vikas Nigam Ltd (GUVNL) (at a levelized tariff of Rs 2.80 per unit) from its coal-fired Salaya II power station on the specious condition that GUVNL failed to satisfy certain conditions under the PPA withing the required timescale.

Now, most people aware of such contracts will agree that these small failures in adhering to commitments are commonplace and are mostly resolved through negotiations without revising the contract itself, leave alone terminating it. Even more curiously, in this case, the decision comes a day after the firm secured a 25-year PPA with the Bihar State Electricity Board to sell 300 MW from its Tori power station in Jharkhand at a significantly higher levelized tariff of Rs 3.28 per kWh. Incidentally, this higher tariff itself was a result of contract reneogtiation on a previous contract with the Bihar government.

All this gives the unmistakable impression that generators can fall back on contract re-negotiations if their aggressive (and even reckless) bidding strategy fails. Interestingly, they appear to believe that they have the choice of forcing re-negotiations not only if they end up facing a situation where they have not effectively managed their risks but also when they have a contract which they find is less profitable than what they want. The Essar example is a clear manifestation of how much the power sector (and its participants) have fallen down the slippery slope of moral hazard arising from contract renegotiations.

This trend raises serious questions about the sanctity of the Union Government's decision to make competitive tariff based power purchases mandatory for distribution utilities across the country. More importantly, they are certain to vitiate the governance environment in power sector and thereby adversely affect the growth of private participation in the sector. It is also another example of how irresponsible private sector participants and complicit governments are altering clearly defined policy frameworks and distorting incentives all-round.

On a related note, the demand for fuel price based renegotiations does raise questions about how the fuel risk should be structured in future contracts, especially where the fuel is imported. Clearly, some form of tariff pass-through is inevitable, as it has become clear that the existing private generators do not have the capacity to adequately hedge for such risks. The inherent nature of the global coal market, where long-term contracts are not available, makes fuel price risk hedging a difficult proposition.

1 comment:

KP said...

Dear Gulzar,

Thanks for highlighting this problem. Could you also provide a pointer to how these risks are mitigated in the US or other economies where there is a similar type of private sector participation.

Is the invoking of a force majeure clause, in the case of higher input cost, legitimate??