Taking out the "take-or-pay" provision

By J R Ruaya

In the heated exchange of charges and counter charges on who is to blame for the country's high electricity costs, the "take-or-pay" provisions in the power purchase agreements (PPA) contracted by the government and the independent power producers (IPP) have been singled out as a major culprit by consumer advocates, left-leaning or populist legislators, media, and virtually by everybody, including the balut vendor.

Listen to some of the recent exchange of barbs:

At the House energy committee hearing, representative Teddy Casiño of Bayan Muna grilled Meralco and the ERC on the take-or-pay provisions in energy supply contracts, citing the case of First Gas, to which Meralco paid the amount equivalent to 1,000 MW of electricity even if it generated only a total of 300 MW from December 2000 to November 2001. This translates to payment of P12.99 billion for this "undelivered power", according to Representative Luis Villafuerte in a privileged speech weeks ago. Meralco, in turn, passed on the additional cost to its consumers.

“What is the basis for the take-or-pay provisions in the IPP supply contracts? This provision in the IPP supply contracts makes their businesses virtually risk-free,” Casiño fumed.

But Meralco president Jesus Francisco said the provision was introduced in the IPP supply contracts during the time of former President Fidel Ramos at a time when the country was experiencing a crisis in power to encourage investors to put up power plants.

The take-or-pay provision however, according to Francisco, would not have posed a problem if the government made an accurate projection of the country’s power requirement." An overly rosy growth forecast by NEDA coupled with the debilitating financial crisis in 1997 resulted in an oversupply of electricity which "we, in accordance with the provisions of the supply contracts, have to pay whether there is actual consumption or not, " said Francisco.

In a statement, First Gas executive vice president Richard B. Tantoco refuted Villafuerte's claim that the company did not deliver to Meralco for 12 months.

"[S]tate-owned Napocor has not kept its part of the bargain on the availability of the transmission lines needed to transport power from the First Gas plant," he said. Back then, the National Transmission Corp. which owns and runs the power grid infrastructure, was still a part of Napocor.

Tantoco was referring to the Sucat-Araneta line and Dasmariñas line, which are part of the government's power development program and the $4.5-billion Malampaya deep water gas-to-power project.

"As records would show, the completion (of these lines, along with the) Zapote substation were delayed by over five years," Tantoco said. "A generating plant without a transmission line to transport power will definitely be stranded."

He said the result of the transmission bottleneck was that First Gas' Sta. Rita 1,000-MW plant and Napocor's 600-MW Calaca coal plant were limited to a total combined dispatch of only 600 to 700 MWs.

The late party-list congressman Crispin Beltran even refused to pay the PPA portion of his electric bill in 2001 as a protest.

At the Senate, the legislators are jostling each other to be the first in line to be a hero to the masses by trying to take out the "take-or-pay" with a sniper fire from the EPIRA.

What is "take-or-pay"?

The "take-or-pay" is a provision within the sales agreement between a buyer and a seller that obligates the buyer to pay a minimum amount of money for a product or a service, even if the product or service is not delivered. These contracts are most often used in the utility industry to back a financing scheme (e.g., bonds) in constructing new power plants. On the finance side, it is a sort of a comfort (collateral) for the lender that the project would have a steady stream of revenues to pay for the principal and interest. The supplier would also have confidence that a continuous extraction of his resource, for example geothermal steam or natural gas, would be viable. The buyer-- for example, the owner of a power plant--would also be assured of fuel to run his generators.

Under the right or normal circumstances, a "take-or-pay" contract should make all the stakeholders concerned happy, or least give some comfort. But the devil advocate here is the term "right" or "normal". Typically, a "take-or-pay" duration spans 15 to 20, or more years. This is to give a semblance of stability and predictability of the contract.

However, given the dynamics of the industry, what is right or normal at the time of the agreement could become rapidly abnormal in a few years--the demand projection could be widely off, a competitive fuel price shoots up through the roof, a financial crisis sets in which causes interest rates to gyrate wildly or currency exchange rates to fluctuate unpredictably, political upheaval which causes drastic changes in policy--and the "take-or-pay" could either be a bonanza or a financial guillotine for any of the parties involved, including the consumers.

Objections to "take-or-pay"

The advent of new technology and liberalization of markets usually make the take or pay provision onerous to the buyer. Newer facilities may produce the same commodity traded at at much lower cost, but the buyer under a take-or-pay provision cannot take advantage of the fall in prices as he is bound by the contract.

Because of the inherent inflexibility of the take or pay contract, buyers cannot adopt rapidly to changing markets, inevitably leading to financial losses. For example, when there was a glut in electricity, NPC could not switch suppliers from the IPPs due to its contractual obligations.

Take or pay contracts is also a negation to the principles of competition which is inherent in a liberalized market. A major aim of competition is to get the best price for the consumers. Buyers under take or pay provisions may no longer be able to pass on their costs to the consumers. In a monopolistic electricity market which we still have, these costs are passed onto us in the form of high electricity prices.

Whenever disputes arise, take or pay litigation can take time and become costly for all the stakeholders. They interrupt the contract and smear the business relationship between the seller and the buyer. Even in the United States, there have been attempts by buyers to get out of onerous contracts through litigation, but in most cases, the sanctity of the contract is held up by the courts of law despite how uneconomic the contract could be.

Take-or-pay provisions promote inefficiency and waste. This is because whether the efforts put into production is minimal or optimum, the revenue stream for the seller is assured.

Possible improvements

Long term contracts with take-or-pay provisions should have a renegotiation clause. The triggering device could be a major shift in the market (whether caused by a disruptive technology or a shift in government policy) wherein the original basis for the contract no longer applies to the prevailing market.

Price adjustment clauses could also render a long term contract adaptable to changes in the market. For example, if say steam price from a geothermal resource is indexed to some energy commodity like coal, a price adjustment can be capped to a level less than the actual price of coal if coal prices suddenly shoots up way beyond projections.

A shorter take or pay duration with a review clause could also benefit the buyer.

Or there could be found an alternative to take or pay altogether.

Enter the IPPs

The term entered into the lexicon of our consumers through the independent power producers (IPPs) in the form of the build-operate (BOT) scheme and its variants, which came in in the early 1990s to help ease the debilitating power shortage experienced by the country. Back then, the situation was hardly normal:the 12-hour rotating brownouts were crippling the industries and citizens were at their boiling points. The country was still feeling the aftershocks of the military adventurism in late 1989 led by then Colonel Gringo Honasan, who went on to be rewarded with a position in the Senate. The new presidency of Fidel Ramos, which came in with less than a clear-cut mandate from the electorate, took over from a wobbly Corazon Aquino regime with hardly any finances to start with.

The IPP is not a cheap power option. The actual price (which is usually much more than the initial cost) we have to pay would be spread out in the years to come. If not for the gracious incentives offered--tax breaks, power purchase agreement including a "take-or-pay" provision--only the bravest or the foolhardy investors would take the government's bait then. In a very uncertain environment, an investor would demand a higher compensation for the risk he is taking. Take it or leave it.

For the financier of these capital-intensive projects, the key principle of financial cost recovery in the power sector is that revenues from electricity sales should fully recover operational expenses and depreciation, and generate a reasonable return on the capital invested. The return specified is based on the weighted average cost of capital, consisting of long-term debt and equity. The take or pay provisions help realize these targets.

The cost of power from the IPPs is necessarily higher than the average generating cost of the existing utilities because of their need to use commercially priced debt with maturities shorter than the useful life of the underlying generation assets, and high returns on equity based on the perceived country risk. To further mitigate the assumed risk, prices were asked to be denominated in U.S. dollars, not in local currency as a shield against currency exchange rate downside.

In addition, the lender requires government guarantee such that a government keen to keep its credit standing would have no choice but to service its debts ahead of social services.

Furthermore, the selected IPPs and concluded power purchase agreements were made on the basis of direct negotiations rather than following transparent international competitive bidding procedures. Such selection and contracting processes also contributed significantly to the high prices received. The agreed prices, with take-or-pay provisions, were expressed in convertible currencies or were fully indexed to exchange rate variations.

Excessive capacities were also contracted on the basis of highly optimistic load forecasts. When, in the later part of the 1990s,

economic growth and electricity demand slowed down, and local currencies depreciated substantially as a result of the Asian financial crisis, the cost of power purchased from IPPs rose substantially in local currency terms. Because of the take-or-pay provisions, utilities frequently had to reduce their own generation and absorb the higher priced output from the IPPs. This seriously eroded the financial viability of utilities; in our case the national Power Corporation (NPC)

Renegotiating the IPP contracts

Theoretically, any contract, including the IPP contracts, is negotiable. Especially if your costly assets are under the threat of forcibly taken away, an option would be negotiation even if reluctantly. The NPC has taken pride in "successfully" re-negotiating some of these contracts, but what would be the effect on the present and future investors?

For one, the country would be perceived as a high risk, with no regard for the sanctity of contracts. Those still looking in would need to do more homework.

How would you feel when the basis of all your financial projections is suddenly shattered by a forcible scrapping of contract provisions. One may have only bear and grin it, if it is still tolerable. But a cat who has sat on a hot stove wouldn't ever sit again even on a cold stove.

But if the demands are excessive--that's another story. When at the height of the financial crisis in late 1990s the Indonesian government demanded that the foreign power producers be paid in the sinking rupiah, many just packed up and went away. Some elevated their cases to international courts of arbitration--and won, but they still have to collect what is due to them.

So, how would you eliminate the hated take-or-pay? By improving the general climate of investment so that the take-or-pay or its variants would be redundant. By eliminating red tape and corruption that have added to the cost of doing business. By stabilizing the political situation so that the financial risk premium would be lowered.

By not excessively taxing the power producers or strangling them with unreasonable environmental demands.

By making the EPIRA work such as accelerating the privatization of generating assets so that a truly, open and competitive power industry be established and equitably assigning the IPP administrators soon.

To bring down the power costs --which is what this is all about--everybody must work hard methodologically, painstakingly and with determination. It takes time and there are no shortcuts.

Let us respect the sanctity of the law like in commercial contracts. Modern commerce is based on mutual respect backed up by law.

Take out the "take-or-pay" forcibly and immediately? The bullet you use in taking out "take-or-pay" might ricochet and maim, if not kill, you instead.