The single buyer model: what is it?
As the debate here in New Zealand, on the Labour and Green’s power policy reform proposals in relation to the electricity wholesale market, rages on, my blog items on Farmin Agreements seem irrelevant. So, I thought I would contribute to the debate by pointing out that some views may be based on a misunderstanding as to what is proposed by Labour and the Greens which is, in turn, driven by the lack of detail as to exactly what they propose.
The latest contribution to the debate that I have read comes from TrustPower chief executive Vince Hawksworth. In an article on Energy News, 21 June 2013 entitled Single-buyer model risks halting project development – Hawksworth, he is reported as having told the Electricity Engineers’ Association conference in Auckland that creating a single-buyer for the generation market would turn development into a “lottery” and could stall the consenting of new projects.
His point (as reported) was that since the creation of the market wholesale prices had been volatile but they had been sufficient for business to invest more than $2 billion on new generation, much of it new renewables. The country also has an extensive list of consented projects that can be developed as needed.
But he says generators are unlikely to go to the expense of consenting new developments under a single-buyer model. TrustPower, which has invested $620 million in New Zealand since the market’s creation, could not justify seeking consents for new projects if their timing was to be decided by a state regulator.
“You don’t want to buy a lottery ticket for when it gets built” he is reported as having said.
To my mind what he says makes perfectly good sense. However, I do not think that this is what is proposed by Labour and the Greens single buyer model.
I am not advocating the Labour and Greens proposals; I am just making the point that there may be some confusion as to what is proposed which is driven by lack of detail.
The Green’s discussion paper Empowering New Zealand says ‘NZ Power will be a ‘single buyer’ – all generation will be sold to it and will onsell to electricity retailers and major users… NZ Power will make long-term contracts with generators and use its market power to negotiate much lower wholesale prices…’ and ‘NZ Power will lock in most of electricity supply it needs by auctioning long-term contracts with generators.’
The Labour party policy document Energising New Zealand says ‘We will establish NZ Power – a new independent Crown entity – to have a central role in the planning and operation of the electricity system, taking a holistic approach’ and that ‘NZ Power will have the ultimate government responsibility for energy sector planning. It will be required to determine future investment needs for generation and seek competitive proposals for the construction of new plant and equipment’.
This tells me that Greens and Labour propose that NZ Power will decide when new generation plant is required and, therefore, will seek competitive proposals for the consenting and construction of new generation as per its planning and not that of the generators. Hence, a competitive proposal would comprise the generator’s proposal for consenting, construction and operation of the new generation plant on a time scale commensurate with NZ Power’s planning which, if successful, would be secured by a long term contract. Therefore, any consenting undertaken by the generator would not be undertaken without a contract with NZ Power in place; there would be a contract in place which provided for consenting, construction and operation with the security of a contracted revenue flow from NZ Power with an implicit Government guarantee. This is not expressed in the Green and Labour discussion and policy documents but, to mind, it is plainly implicit as, otherwise, an advantage of the single buyer model is not obtained. The UK Energy Research Centre in its paper Electricity Market Design for a Low-carbon Future, October 2010, said ‘…the guaranteed income stream associated [with] a single buyer model would improve investor confidence and reduce the cost of capital’.
However, this may be outweighed by other factors. For example, the concentration of planning and the timing of new generation in NZ Power as the single buyer and central planner may magnify the consequences of planning or forecast error, as happened in the 1990s; over investment might be expected – the incentive to avoid any security of supply failure, in turn leading to less innovative and more conservative planning; and, finally, NZ Power might be expected to be not so good as a competitive wholesale market in sustaining pressure on operational costs. These were the factors which have influenced the decision making of previous Governments.
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Single-buyer model and farmout agreements. How about that!
It was great to see that my blog published in Energy News www.energynews.co.nz on the single-buyer model stimulated some comment. I agree with many of the comments including the risk or inevitability of direct or indirect political interference.
Before the blog on the single-buyer model I had been blogging on farmouts and I have now asked myself whether contracting by NZ Power as the single buyer and contacting by the farmor had anything in common?
To state the obvious, they both involve long term contracts e.g. NZ Power would contract for the consenting, development and operation of the generation plant and in exchange the generator would get paid; the farmor will contract for a contribution to the funding of or performance of the whole or part of the permit work programme (and/or cash) and in exchange the farminee will obtain an interest in the permit for its full term with which it can deal subject to the terms of the JOA and the Minister of Energy’s consent. Hence, the traditional long term contracting risks of security of reserves/ feedstock, non-completion, sub optimal operation, force majeure, political interference/changes in law and change in market (price) conditions have to be identified and allocated with appropriate contractual mechanisms to the extent practicable.
What about the risk of political interference?
A contract can address the risk of political interference by way of change in law in various ways e.g. in the case where the counterparty is the Government or a Government related party, by allocating the risk to that party by way of an indemnity perhaps limited to changes in law which discriminate against the contract or the non-government contracting party and/or, where a certain revenue flow has been promised, changes to the fiscal regime which impact on that revenue flow; and, in the case where the contracting parties are independent of the Government, by the risk being shared with each party having to bear any associated costs unless or until there is a material adverse impact and/or by having reciprocal rights of termination of the contract.
However, in the case of the single-buyer model, the concerns are more directed to political interference in the decision making by NZ Power. I suggest that the same issue can arise in the case of the farmout, or other contracts between private parties, in that the farminee or the counter party can be the subject of interference by its ultimate parent company. Also the farminee or counterparty might have significant market power which gives rise to concerns similar to that when contracting with the Government or a Government monopoly (as NZ Power would be)
In case of decision making independent of the contract (i.e. not pursuant to a power conferred by the contract), NZ Power would probably be exercising a statutory power of decision which would be subject to judicial review but such, generally speaking, goes only to the decision making process rather than the merits of decision itself but this may to some degree restrain the extent of influence. The farminee or other contracting party with market power would only be restrained by the general law e.g. perhaps to some extent, by the trade practices provisions of the Commerce Act. Hence, recourse to the law as a means to mitigate the risk of interference in this decision making is limited.
More can be achieved in the case of decision making under the contract i.e. pursuant to a power conferred by the contract. First, the contract can be prescriptive as to outcomes and performance levels which limit the scope for influence. Secondly, the contract can provide for legal sanction so as to, in effect, enable judicial review of the decision making process and the merits of the decision itself e.g. provisions that the exercise of a discretionary power must be made after disclosure of relevant information, consultation and in good faith and/or in accordance with a prescribed criteria and that the decision itself must be reasonable.
Hence, contracting by NZ Power as the single buyer and contacting by the farmor have points in common in that decision making under the contract, whether the subject of influence or not, can be the subject of legal sanctions. In the case of decision making outside the contract, the law can only provide limited protection against interference by those with political or market power and, therefore, the nature of the beast (NZ Power in the case of the single buyer model and the farminee in the case of the farmout) becomes critical.
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Is a16.44% regulated return on equity of interest to anyone?
The Philippines Energy Regulatory Commission approved recently a Power Sale Agreement under which the seller is to construct a 119MW coal fired power plant for an approved US$220.36 million and obtain a pre-tax WACC of 12.30% (post tax 8.61%) and a 16.44% cost of equity (based on70/30 debt/equity funding)..
The circumstances are interesting and are attractive to investors.
The seller is a Philippines based generator and the buyer is an Electric Cooperative which has a franchise to distribute and supply electricity to consumers in the Philippines city of Zamboanga on the island of Mindanao.
Electric Cooperative are non-profit cooperatives recognised by the Philippines legislation as authorised and having a mandate to supply power to its connected consumers in defined impoverished areas of the country. In this case the Electric Cooperative buyer is connected to the Mindanao grid. Mindanao is the second largest and southernmost major island in the Philippines with a population of 22 million plus. Many areas in Mindanao suffer rolling 12-hour blackouts due to the island’s woefully inadequate power supply. Given the special needs of Mindanao, the Mindanao grid is excluded from the Philippines WESM (the deregulated and competitive wholesale market) and the industry on the island is regulated at all functional levels by the Energy Regulatory Commission.
The Electric cooperative buyer is unable to meet the demand of its consumers but is required to ensure that the demand is covered by new supply contracts from new generators given that the traditional supplier, the state-owned generator, is not allowed to construct new capacity. This is part of the grand scheme to privatize the industry as set out in my previous blog item. Thus, the Energy Regulatory Commission accepted that there was a clear need for the proposed power plant and the power supply agreement. Indeed, the seller generator is only one on many looking to invest. The Manila Electric Company (Meralco), the largest power distributor in the Philippines, and Global Business Power Corp. also a major provider, have announced plans to enter Mindanao for the first time to establish solutions for the power problems within the island.
The Power Supply Agreement contemplates the construction of a circulating fluidized bed combuster boiler coal fired power plant with an installed capacity of 119 MW and a net dependable capacity of 105 MW (the capacity guaranteed by the EPC contractor) and supply for buyer’s baselaod requirements up to a contracted capacity of 85 MW for a term of 25 years at different rates for commissioning and commercial operations. The tariff or rate structure is as follows:
• A Capital Recovery Fee to recover seller’s capital (debt and equity) and rate of return
• A Fixed Operation and Maintenance Fee to cover the operating and maintenance costs of the power plant
• A Variable Operation and Maintenance Fee to cover the cost of consumables, spare parts and other items directly related to production
• Actual Fuel Cost being a pass through of the actual cost of the coal feedstock
• Start-Up Costs to cover the cost of starting up the plant after any period of shut down for any reason attributable to the buyer
• A Replacement Capacity and Energy Charge to cover the cost to seller in obtaining replacement electricity during any allowed outages
• A Back-up Capacity and Energy charge to cover the cost to seller in obtaining replacement electricity during any forced outages (those outside the allowed limits)
• An Interconnection Capital Recovery Fee to cover the capital costs of grid connection (divided into components to reflect the portions capital cost funded by foreign capital and domestic capital)
The tariff or rate structure and the methodology for the calculation of the amounts payable were reviewed by the Regulator but the major focus was on the WACC recovered by the Capital Recovery Fee.
The essential elements of the Regulator’s approval was as follows:
• The capital cost of the power plant was approved by reference to the EPC contract and other estimated project costs
• The 70:30 debt-equity ratio was approved by reference to sellers actual debt—equity funding for the project
• The cost of debt (7.50% pre-tax and 5.25 post-tax) was adopted as being the actual cost of debt as per the terms and conditions of seller’s loan facility negotiated with the lenders (a syndicate of Philippines based banks)
• Seller’s proposed cost of equity of 19.40% was rejected but 16.44% was approved, it being the Regulator’s established practice to accept this as being a reasonable cost of equity. Not bad, eh!
The result: a Capital Recovery Fee which recovers a pre-tax WACC of 12.30% (8.61% post-tax).
No wonder other participants in the Philippine’s electricity industry are starting to line up to invest in Mindanao to to establish solutions for the power problems within the island, especially given that such is consistent with the political objectives of a relatively stable and ‘pro-privatization’ administration of the Republic of Philippines.
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Is a16.44% regulated return on equity of any interest?
The Philippines Energy Regulatory Commission approved recently a Power Sale Agreement under which the seller is to construct a 119MW coal fired power plant for an approved US$220.36 million and obtain a pre-tax WACC of 12.30% (post tax 8.61%) and a 16.44% cost of equity (based on70/30 debt/equity funding)..
The circumstances are interesting and do attract investors.
The seller is a Philippines based generator and the buyer is an Electric Cooperative which has a franchise to distribute and supply electricity to consumers in the Philippines City of Zamboanga.
Electric Cooperative are non-profit cooperatives recognised by the Philippines legislation as authorised and having a mandate to supply power to its connected consumers. In this case the Electric Cooperative buyer is connected to the Mindanao grid. Mindanao is the second largest and southernmost major island in the Philippines with a population of 22 million plus. Many areas in Mindanao suffer rolling 12-hour blackouts due to the island’s woefully inadequate power supply. Given the special needs of Mindanao, the Mindanao grid is excluded from the Philippines WESM (the deregulated and competitive wholesale market) and the industry on the island is regulated at all functional levels by the Energy Regulatory Commission.
The Electric cooperative buyer is unable to meet the demand for of its consumers and is required to ensure that the demand is covered by supply contracts. Thus the Energy Regulatory Commission accepted that there was a clear need for the proposed power plant and the power supply agreement. Indeed the seller generator is only one on many looking to invest. The Manila Electric Company (Meralco), the largest power distributor in the Philippines, and Global Business Power Corp (GBPC), also a major provider, have announced plans to enter Mindanao for the first time to establish solutions for the power problems within the island.
The Power Supply Agreement contemplates the construction of a circulating fluidized bed combuster boiler coal fired power plant with an installed capacity of 119 MW and a net dependable capacity of 105 MW (the capacity guaranteed by the EPC contractor) and supply for buyer’s baselaod requirements up to a contracted capacity of 85 MW for a term of 25 years a different rates for commissioning and commercial operations. The tariff or rate structure is as follows:
A Capital Recovery Fee to recover seller’s capital (debt and equity) and rate of return
A Fixed Operation and Maintenance Fee to cover the operating and maintenance costs of the power plant
A Variable Operation and Maintenance Fee to cover the cost of consumables, spare parts and other items directly related to production
Actual Fuel Cost being a pass through of the actual cost of the coal feedstock
Start-Up Costs to cover the cost of starting up the plant after any period of shut down for any reason attributable to the buyer
A Replacement Capacity and Energy Charge to cover the cost to seller in obtaining replacement electricity during any allowed outages
A Back-up Capacity and Energy charge to cover the cost to seller in obtaining replacement electricity during any forced outages (those outside the allowed limits)
An Interconnection Capital Recovery Fee to cover the capital costs of grid connection (divided into components to reflect the portions capital cost funded by foreign capital and domestic capital)
The tariff or rate structure was reviewd by the
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