I recently came across and found the time to re-read a material written by renowned Energy scholar,the late Simon Awerbuch. I first encountered Awerbuch’s readings a few years ago. That article made me really reflect and understand why our consumer on the street, Juan de la Cruz, is probably getting a bad deal in his electricity prices.
In the material, Awerbuch discussed the Capital Asset Pricing Model (CAPM), and the importance of reviewing the traditional methods used in estimating electricity costs. He asserted that traditional energy planning fails to consider the risk of price volatility of fossil fuels, which, unfortunately, has a negative correlation with the economy.
We use CAPM in our tariff setting. In my view, the concept is misused. The reading made me think that if only our energy planners and regulators take the time to understand the concept and make the changes needed, then we will surely have lower power rates
For a long time, we in the power sector have been using the “least cost” approach to analyze which sources of power are cheapest or the most economical to use in the system. We do this by comparing technologies where we conclude that certain fuel sources are “cheaper” than others. To exacerbate this further, we then go on and regulate what can be passed on to consumers based on the returns we want to give to investors rather than what consumers want nor deserve.
And for the Nth time, I say, we got this all wrong. This is the reason why we find it extremely difficult to bring down power rates.
We need to look at our Power Sales Agreement or PSAs to understand what we are doing wrong. Reduction of energy cost is simple: regardless of the technology, introducing fixed-price long-term contracts will REDUCE power rates.
To understand the need to introduce fixed-price-long term contract, we first need to review the use of what I call the ‘floating’ power sales agreement.
Generally, PSAs have provisions to “pass through” or “pass on” foreign exchange and fuel prices to the end consumers. It is my contention that once we minimize PSAs with “pass through” or “pass on” rates and replace them with fixed price long-term contracts, we can truly bring down power prices. Otherwise, as my good friend says, these “pass on” contracts will have to be, in the Visayan language, “pas-an” (to be carried) by the consumers.
In my other articles, I have always asked the question: which is cheaper, a floating PSA that is currently priced at P5.00/kWh or a fixed price PSA that is fixed at P5.10/kWh for 25 years? The traditional analysis will say it is the floating P5.00/kWh. In fact, the way “rate impact” studies are done, most utilities calculate only the first year tariff and weigh the implications of that tariff when added to the current average tariff of the entire energy mix. The traditional analysis will conclude that, indeed, a floating P5.00/kWh is cheaper than a fixed P5.10/kWh.
Unfortunately, such analysis does not consider the possibility that the floating PSA can reach P10.00/kWh the following year should the value of the peso fall against foreign denominations or prices of fuel or coal significantly increase.
Choosing the ‘floating’ price is counter intuitive. Any businessman or even a housewife would rather pay a known fixed price because, from a budgeting perspective, it is far more convenient. And more importantly, it is actually, conceptually cheaper. It is cheaper because the cost to hedge either the fuel or forex risk will have to be added on the P5.00/kWh if one is to adjust the cost of a floating PSA to reflect current prices of fuel or value of peso against a foreign denomination. And that is assuming there is such a hedge for 20 years.
But why is this penchant for choosing the floating PSAs embedded in our regulatory framework? For this, we can point to the calculation of the Weighted Average Cost of Capital (WACC) when computing for the Return on Equity (ROE) in the determination of the appropriate tariff for a particular PSA. Our regulators use the CAPM for tariff setting, but unfortunately, use an incorrect value for the beta in the computation. Our regulators assume that the beta has a positive value, which signifies that the return to the generator is positively correlated to the economy.
This indeed is a faulty assumption especially if used in the tariff setting for fossil-powered plants. On the contrary, studies have shown that oil price volatility has a negative relationship on macroeconomic activities. Awerbuch, simplified it best: financial betas of fossil prices must also be negative.
The above point leads me to the bigger, and more important question: why is the rate setting evaluated from the point of view of the generator? Since the consumer is taking the forex and fuel risks anyway, shouldn’t the consumer’s perspective be taken instead? Shouldn’t we use the beta for consumers for a floating PSA instead of the beta of the generator?
First of all, we need to look at who bears the risk of having a volatile price. How is Juan de la Cruz compensated for taking on this risk? This question is not even being asked right now. This has to be asked because, in reality, Juan de la Cruz will end up subsidizing the generators if we insist on assuming a positive of the beta of the floating PSAs.
Given that we are calculating the required ROE in the WACC using a flawed “beta,” then the generators are getting a ROE far greater than they deserve. This leaves Juan de la Cruz in a sorry state.
BUT if we take on the perspective of the consumer, then the entire story changes.
If we want to compensate Juan de la Cruz for taking the volatility risk, then we must consider the financial evaluation of the floating PSAs. Otherwise, the traditional assessment will show that Juan de la Cruz is getting a “cheaper” floating PSA. However, this is a fallacy. The proof of which can be seen from a mathematical calculation using the CAPM.
Take a look at the table above. Clearly, the floating PSA is riskier for the consumer than the fixed PSA because, again, the consumer bears the cost of the forex and fuel risk. Or to put it simply, the consumers pay more for the fuel and forex upward adjustments.
Now we have to ask: how much is Juan de la Cruz really paying for each type of contract?
A static price comparison obviously is wrong. One cannot compare one price alone, let us say a P5.0/kWh for a floating PSA versus P5.10 for a 20-year fixed-price contract. We MUST take into consideration the WHOLE contract period.
It is however, IMPOSSIBLE to predict the future prices of fuel and the foreign exchange. And one cannot possibly put the future prices inside the contract. This is the reason why these volatile costs are “pass through” or “pass on.” It is the consumers who will pay for the adjustments above the P5.0/kWh.
This begs the question of how to account for this uncertainty in the evaluation of cost for Juan de la Cruz.
The fixed PSA, on the other hand, is easy to figure out: it is fixed.
So, how can one evaluate what the real cost is for Juan de la Cruz? Common sense will tell you, the fixed price – as long as it is priced correctly – will be always be advantageous to Juan de la Cruz, all other things being equal.
Mathematically it can also be proven. We still use the CAPM– the very same formula that is being used to determine the appropriateness of the tariff–except that this time, we use the CAPM from the point of view of Juan de la Cruz rather than the one of the generator.
The formula above says the discount rate of any asset is equal to the risk-free rate plus a premium. This premium is represented by the market return (MR) adjusted for the sensitivity of the asset to the return of the market. Generally, in modern finance, the market return (MR) is defined as the return of the entire stock exchange, and the beta is the correlation coefficient of a particular stock against the return of the market.
If a stock’s price goes up or down with the market, then we say that stock is POSITIVELY correlated with the market. The beta then will be a POSITIVE number. If the stock’s price goes up when the market goes down and vice versa, then we say that stock is NEGATIVELY correlated with the market. Then that beta will be a NEGATIVE NUMBER. If a stock price stays constant regardless of the behavior of the market, then we can say it has NO CORRELATION with the market. Then the beta will be ZERO.
Let us now apply the concept in evaluating the floating PSA versus the fixed PSA.
Let’s start with the easy one – the fixed price.
Since the price of the PSA is fixed (in real terms), then we can say it has NO CORRELATION with the movements in the fuel price or forex. Or to put it simply from a consumer’s perspective—the consumer will pay the same price regardless of the fuel prices or forex. So, the beta will be ZERO, which means the discount rate we should use will be the risk-free rate. Let me go back to this number later when we do the analysis.
How do we handle the case of the “pass on” or floating PSAs?
Volatile prices, in general, will be NEGATIVELY correlated to the market, so the beta is a negative number. A simpler analogy is this: if the price of fuel or the cost of forex goes up, the value of the PSA goes down (becomes more expensive.) On the other hand, if the cost of fuel or forex goes down, the value of the PSA goes up (becomes less expensive). Clearly, there is a NEGATIVE correlation between a volatile PSA and the market.
Applying this logic to the CAPM, one will see that the discount rate for the fixed PSA will always be higher than the discount rate for the volatile or floating PSA (mathematical proof available upon request.) The reason is simple. In the case of the fixed price contract, we discount the price at the risk-free rate.
On the other hand, in the case of the floating contract, we discount the price at a rate LOWER than the risk-free rate. Discounting at this lower discount rate will result in a higher price than one that is discounted at the higher discount rate. That the mathematical truth.
How do we translate this to Juan de la Cruz?
This simply means, ceteris paribus, a fixed price contract will ALWAYS be lower than a floating volatile contract. And any analysis that does not take this into consideration is doing a disservice to the consumers. This also means that putting a fixed price contract into a utility’s energy mix will lead to LOWER power rates.
There is no magic in the CAPM formula. After all, anyone with some basic knowledge of calculus and finance can calculate using that formula. The major shift here is this: we should use the discount rate relevant to Juan de la Cruz rather than to the generator. It is the consumer taking the fuel and forex risks. Hence, he must be compensated for taking on that risk. Using the generator’s beta (most likely greater than 1) to evaluate the PSA is wrong because the one paying the tariff is Juan dela Cruz and not the generator.
I am not saying that we should totally ignore floating PSAs. Floating PSAs generally are associated with fossil fuel-based contracts. I think the late Prof Awerbuch hit the nail on the head with his article. As he pointed out, “The CAPM analysis highlights some important implications of the negative correlation between energy prices and the economy, suggesting a broader conceptualization of energy security that reflects the deleterious economic effects of fossil volatility. These effects can be measured and reduced by incorporating technologies such as wind, geothermal and PV, whose underlying costs are uncorrelated to fossil prices. Fossil price risk can be mitigated only through such diversification.”
Unless this shift is made, Juan de la Cruz will always be screwed. It will be the consumer who will “pas-an” the generator because of the “pass on” nature of the volatile PSA.
Time to change.