Privatizing the Agus and Pulangi Hydropower Plants: An Alternative

Published in Mindanews.com March 7,2015

http://www.mindanews.com/mindaviews/2015/03/07/commentary-privatizing-the-agus-and-pulangi-hydropower-plants-an-alternative/

For those of you old enough to remember, I was appointed to the National Power Corporation (NPC) Board in 1992 by then President Fidel V. Ramos (PFVR) with an unwritten mandate of finding a permanent solution to Mindanao’s power woes. I ended up running the entire company, mandated to solve the power crisis then and find a long-lasting solution to the power crisis not only for Mindanao, but for the entire country.

For the record, I did try to find a long-term solution to Mindanao’s power woes. The current STEAG Coal-fired power plant (in Misamis Oriental) was the last contract I signed a few days before I retired in June 1998. I fought hard for that plant to the point that many politicians, including our very own who are enjoying the benefits of that plant, said it was a “midnight” deal. Of course, hindsight has a 20/20 vision; Mindanao enjoyed a far more stable power supply with the STEAG plant in spite of the crisis that crops up every now and then.

Discussions back then hovered around the creation of Mindanao Power Corporation, a discussion still very much alive today. Of course, privatization and liberalization issues for the Mindanao grid were hot topics in the past, as it is today. That is a topic I may write about another time. Today, in the solitude of my present life as a private citizen, I cannot help, but with a wry smile, think about the complexities of making certain decisions today like the privatization of the Agus and Pulangi complexes.

The Power Sector Assets and Liabilities Management (PSALM) Corp. said it will proceed with the sale of the Agus and Pulangi plants after the approval of its board last year. In previous interviews, PSALM President Emmanuel Ledesma Jr. said that the sale is due in 2017 — the earliest sale date. He also added that an amendment to the EPIRA is the only way to prevent the sale of the hydro power plants.

Can PSALM privatize Agus and Pulangi plants according to its timeline? In fact, should PSALM privatize the plants according to the government’s current plan?

Probably not. For one, those who oppose the privatization of the power plants of Mindanao are many and they raise valid points. There are many who will push for the private sector’s participation in the sector and I would be one of them. If I have hesitations about this current plan, it is because I know there is a better way of privatizing the plants. Hence, much more thought must be put into the plan.

It is a very big challenge privatizing the Mindanao hydropower complexes.

The hydro plants with a combined capacity of 982 megawatts installed capacity is too large to sell to a lone owner. Having the plant owned by a single entity will result in a near monopoly market structure —a situation that the government must avoid since the essence of EPIRA is to promote fair competition among players.

If PSALM does not sell the entire power plant to a single entity or owner, and then it would be forced to sell the plant in parts or in blocs. This too, seems problematic since breaking up the complex will complicate the water management of the entire complex. The Agus complex is essentially a single complex with cascading power plants downstream from Lake Lanao. It is essential for the operations and maintenance activities of the plants to be optimized and synchronized. This will make the operations complex, and the financial contracts even more complicated.

Is there a viable option in privatizing the Agus and Pulangi Plants, one that will keep the interests of the consumers in mind without sacrificing the efficiency of private sector funding and management? I believe there is a possible option, one that we had planned for Mindanao during our time in government.

Privatizing the hydropower complexes must always bear the consumers’ interests in mind, far above the interests of the private investors and the government’s. This is a policy that should be paramount in the privatization of any government monopoly. In the case of Mindanao, the question is this: how can the Mindanawons of today enjoy the benefits of the Agus and Pulangi hydropower complexes in the years to come?

A few weeks before I retired from NPC in 1998, I implemented a power sales policy in NPC where I sold, proportionately, the output of Agus to all the consumers of Mindanao at some fixed rate for the next 20-odd years. The purpose was to “lock in” the low price of hydropower by way of a contract. Unfortunately, only Davao Light then took on that offer; only Davao consumers benefited from this undertaking.

This time around, PSALM must enter into Power Supply Agreements or PSAs with a life of 25 years before it starts selling the hydro plants. This time, this should benefit all existing customers of NPC – electric cooperatives, private utilities, and directly-connected industries. The reason is simple: PSALM should avoid the pitfalls of the government in previous privatization deals where the government sold plants individually without any PSA. Doing this will result in either of the following situations: a) prices will go up immediately after privatization; and/or b) government sale price will be low. Either way, the government and consumers will be the losers in the equation.

The PSA must be signed by all of the NPCs existing customers at the current price with escalating prices based on the consumer price index (CPI) to reflect inflation. This makes the price of the generated power by the power plants determinable in the next 25 years. This makes the economy of Mindanao more stable with relatively determinable costs. Having this type of a PSA where the price is stable will bring down over-all risks of the Mindanao economy and can contribute to a higher GDP growth for the island.

In particular, this will benefit small and medium enterprises (SMEs) that tend to suffer more than large multinationals in times of uncertainty. Studies have shown that stable and predictable prices have a positive effect on the over-all GDP growth of economies. This will, again, be a topic for another time. Suffice it to say that having a long-term PSAs will benefit everyone – for the government and the investing public, the price is easier to determine and establish. For the consumers, they are protected against price spikes in the long-run and will benefit from the stable price that can come from the hydropower complexes.

As for the water management issue, the best option for PSALM is to first obtain the services of an independent water management body that will oversee the protocols of water management. This way, there will be an independent body that will allocate and manage the water based on safety, security, and economic dispatch protocols. And because the PSAs for the complexes have already been signed, there is no need to even have several small “Agus” power companies competing against each other for customers. Asus can have one company efficiently managing the entire complex and Pulangi can have another private company.

Now the bidders will only have to compete based on their capability to rehabilitate and maintain the power plants. Technical competence backed up by experience will drive the bidding which will make the bidding more interesting and beneficial for Mindanao consumers. The current NPC employees with proper financial and management support can very well run these plants. They are the most experienced and competent in the region today.

With this proposed structure, the government now has an option of privatizing the complexes in various ways since the cash inflow is also predetermined for the coming years. For those of us who are familiar with project finance, the structure lends itself to non-recourse financing. Translation: privatization will no longer require investors with large balance sheets because debt financing can be raised through the established PSAs. This means competition for the privatization will be more intense, hopefully increasing the price that investors will be willing to pay for the assets.

In fact, one can think of a scheme where these assets can be sold by way of share sales reminiscent of the way Petron was sold in the past. In that scheme, ordinary Filipinos were able to own shares through SSS and GSIS financing. Privatizing the Mindanao complexes will even be better and easier because of the PSAs – valuation is easier, making financing even easier. One can design a privatization plan where allocation of shares can be done so that every qualified investor in in Mindanao can own a share in these plants.

We have studies done in the past that showed that consumers can actually afford to buy shares from privatized NPC power plants. Every time we pay our electricity bill, a portion actually goes to the capital recovery of these power plants. So why not allocate a portion of this bill to payment of shares? The shares can then be listed in the Philippine Stock Exchange contributing further to the liquidity of the shares and most likely enhancing even further the value of these shares.

I started by saying we studied the different options of creating the Mindanao Power Corporation. We, in fact, went beyond this. We studied the feasibility of creating a market in Mindanao. We eventually ended with this conclusion: given the economic structure of Mindanao, a competitive market may not be feasible. Placing Mindanao as part of the over-all Philippine electricity market may not also be politically feasible; Mindanao has the ability to survive as an autarky in power. The need to physically connect to Luzon or Visayas was not necessary.

These were studies done close to two decades ago. Whether the findings are still valid today may be interesting to re-visit. Maybe, just maybe, the hydropower complex’s privatization may form the roots of a Mindanao Power Corporation. A Mindanao Power Corporation owned by Mindanawons? A great possibility indeed! Just a thought.

“LEAST COST” IN POWER PLANNING IS NO LONGER VALID TODAY

“Least cost” is the term the power industry uses in defining what power plants or projects to prioritize. Conventional thought and the resulting software and techniques in the industry use this term to define the least cost of producing electricity.  Given what we see today — the blackouts, the sharp rise in fuel prices — my view is that this two-dimensional and traditional method of calculating “least cost” is no longer valid today.  This traditional approach has exacerbated the problems that we face in the Philippines today.

Almost all software used in energy planning has the same objective: optimize cost or find the least cost. Due to the advent of computers, planners use the Monte Carlo analyzes (the method of approximating probabilities of several outcomes) of thousands of scenarios to calculate “the least cost.”  The scenarios include different seasons, rain fall intensity, temperature, transient faults and coal prices, among others.

There are software that run the above-mentioned scenarios and are available in the market. For example, QuantRisk uses Monte Carlo simulation for calibration, back-testing and execution of risk valuation in energy planning. This software considers all risk indicators that include market and counterparty exposure and credit risks. It can also compute for regulatory risks, but this is hardly applicable in the Philippines since there are no regulatory risks involved as the ERC bilateral rate structure is used for pricing.

Similarly, other software such as Promod and Plexos are also used for forecasting electricity market prices and analyzing market power, production costs and resource operations, and estimate both fuel requirements, as well as air emissions.

In general, these software, once broken down to the basics, use linear algebra in calculating for these numbers– a two-dimension calculation of scenarios and prices.

In energy planning, finding the least cost comes with ensuring the security of the system–making certain that the system does not collapse since there is a continuous power supply available for dispatch. This means that plants that can provide more stable energy supply and are more expensive to run, and plants that cost lower to run but cannot provide a stable source of power are included in the system So, the system will include different power plants that can “secure the system” regardless of the cost of running these plants.

The numbers that will ultimately come out using software for energy planning will show the hierarchy of prices or costs of the different power plants within the system.  So, it is possible that a coal plant may show a price of say P5.00/kWh while a geothermal power plant may show, for example, P5.80/kWh. Conventional wisdom will then tell us that coal is cheaper than geothermal, right?

Not necessarily.  We may be completely wrong.

 Geothermal power plant. Geothermal or coal-fired power? www.iwnsvg.com

Geothermal power plant. Geothermal or coal-fired power?  Photo from http://www.iwnsvg.com

Remember my argument about comparing car prices? Each car represents a certain value proposition against a milieu of risks associated with the car. We cannot compare a Chery car against a Volvo as each will have its own characteristics distinctly different from each other and appealing to buyers in different ways.  It will boil down to the personal choices of the buyers.

In the case of the coal versus geothermal example, we then ask whether a fluctuating P5.00/kWh coal-fired power price is really cheaper than a P5.80/kWh geothermal fixed price. Maybe for someone who is looking at a very short-term time frame, and then, the answer is YES.  From a different time perspective, the geothermal fixed price may be more attractive since those who are looking for price stability and predictability, the geothermal price is definitely better than the coal one.

Generally, traditional power planning uses the least cost generation methodology where planners add stand-alone costs. The least cost generation method, however does not compute for the risks involved. The risks are identified and scenarios are calculated according to different scenarios, but the costs of these risks are not calculated into the equation. This is highly problematic. After all, talking about costs without talking about risks is like watching a musical movie without the sound!

A risk, which we never took seriously in the past, is Indonesia’s changing rules about exporting coal.  A few years back, Indonesia suddenly decided that it will not allow the export of certain grades of coal.  This led to a much higher cost for coal-fired power plant operators in the Philippines.  One company started to bleed because its ERC-approved formula did not take into consideration the fundamental change in the base prices.

To look at a price without considering risks behind the price can lead us to a completely wrong decision.

In his book, The Black Swan, Nicholas Taleb speaks of events that are completely coming from the left field that conventional method or processes that try to manage risks are simply no longer adequate.  “Sendong” for Cagayan de Oro was a “Black Swan” event.  Nobody alive today would have thought that it would happen.  And yet, it did.

Calculating the “least cost” for the power sector, in particular, would then be a dangerous process in this age of “Black Swans.”  In a paper he wrote in May 2004, the late Professor Shimon Awerbuch of the University of Sussex clearly stated: “Traditional electricity planning processes focus on finding the least-cost generating alternative. Given today’s dynamic and uncertain environment however it is impossible to correctly identify the 30-year ‘least cost’ option, assuming such an option exists.”

Energy planners should start looking at a portfolio of power plants and calculate the portfolio costs given the different levels of risk. To illustrate, we can compare 100% completely renewable energy system versus a 100% coal-based energy system. From an energy cost perspective, in general, one can say the cost for the 100% renewable energy system is fixed in the long-term. One cannot say the same thing for coal since prices fluctuate everyday.  More so, coal is finite, at least depending on the cost to mine and the resulting global price. On the other hand, higher investments may be required for the renewable energy system compared to the coal-based one.

So which one will be preferred: a fixed price system with higher initial investments, or a fluctuating price with lower CAPEX upfront?

This is hard to say as this will depend on the capacity of the consuming public to take on these risks. Or, in fact, it depends on the individual preferences of the consuming public – some may want renewable energy for a completely different reason e.g. “I love the Earth” that does not come with any mathematical equation.

In Finance, concepts like Markowitz’s Portfolio Theory have been introduced half a century ago to explain how putting individual assets in a portfolio can attain a lower risk or a higher return compared to investing in just one asset. In other words, assets should not be bought on its own merits, but rather on how that asset behaves in a portfolio. In our example, we should not be comparing the renewable energy system versus the coal-based system.  According to this theory, it will be make more sense to look at the costs and the risks of the two systems combined at different proportions.

This is how energy planning should be made: a portfolio approach, rather than a “least cost” approach.  In the view of the late Prof. Awerbuch in the same paper cited above noted that “Energy planning represents an investment- decision problem and investors commonly apply portfolio theory to manage risk and maximize portfolio performance under a variety of unpredictable economic outcomes. Energy planning techniques need to focus less on trying to identify the least-cost alternative and more on developing optimal generating portfolios that minimize cost for given levels of risk.”

In my opinion, unless we abandon this “least-cost” approach, the Philippines will continue to face huge supply and price risks.  Luzon and Visayas will soon suffer the same Mindanao power situation of continuous power interruptions, and this will continue to happen for as long as we insist on this “least-cost” approach.  I agree with the late Prof. Awerbuch since given what we are experiencing today, we really need to re-think and maybe completely abandon traditional stand-alone kWh generating costs measures and go for portfolio planning.

We need a major overhaul in our energy planning, and we need it now.

MY CSR: EDUCATION AND THE FAMILY

I remember growing up as a boy in Mindanao seeing my father getting on his green bike to go to Ateneo de Zamboanga where he was a Math and English teacher. He must have been a popular teacher because I remember the throngs of students who would come to our house for tutoring. Some of these students are still around today and still commend my father’s influence on their professional and personal lives. He might have been popular, but this popularity was derived from being tough and unrelenting on his students.

My father’s passion for education, I believe, was driven by the fact that as one of the youngest in a family of 11, he was the only one who graduated with a college degree. A high school valedictorian, my father graduated from the Ateneo de Zamboanga as one of its brightest students. It was no wonder that he wanted to “give back” to his alma mater by becoming one of its teachers.  He was later asked to teach at the Ateneo de Cagayan (now Xavier University) where he met my mother, Gloria, also a teacher.

My father was especially tough on us, his children. He would spend nights breathing down on my neck, making sure I got the exercises by Hart (Algebra) correctly and within a defined time limit. That’s the reason I was already tackling college calculus long before my high school classmates could do algebra. Both my sisters went to the Philippine Science High School, and we all went to UP. Jesus P. Delgado was my father, an educator.

My father died many years ago, penniless.

Our house, a nipa one, was however the center of educational excellence. Today, I have a sister who finished law, nursing and a PhD degree in a field I can no longer remember.  I have another sister who must have finished three masteral degrees in applied mathematics and who is mother to two Harvard physics graduates. My mother, who is 83 years old, took up law when she was 64 years old and became  a lawyer shortly before she was 70. She has four other degrees. And while I am not in the habit of trumpeting my own achievements, let me just say today that unlike my father, I am not an educator, and I am not penniless.

My father may have died penniless, but he did not die poor. He gave us what all of us must have in life: a good and proper education. In that he was a very wealthy man, a very wealthy man indeed. And this drives my passion to use my corporate vehicles, my businesses as means to support education in this country.

Education is so basic that if our society cannot give that to our children, to our youth, and then that would be criminal. No one can survive these times without education. A democracy, in fact, requires that its citizenry achieve a certain level of education that will make them intellectually independent to make informed choices when choosing political leaders.  Any country that fails to educate its citizens effectively relegates them to slavery and poverty.  That’s why we find it deplorable to hear of countries that continue to deny education to its citizens on the basis of gender or race.

The challenge of education however, goes beyond our ability to teach or to provide classrooms.  It demands that we have healthy children.  No, in fact, it requires that these children are kept healthy even before they are born. Their mothers must have the proper nourishment to ensure the proper nutrients are provided to the fetus.  Studies have shown that more than half of Filipino children are already bound to fail to get a proper education due to malnourishment.  Their learning capabilities are severely diminished as a result of their poor health.

Malnutrition among Filipino children is still prevalent. Graphics courtesy of Fil

Malnutrition among Filipino children is still prevalent. Graphics courtesy of Rappler.com

 

We need to have a healthy society for education to succeed. Mens sana in corpore sano: a sound mind in a sound body. Our children have lost the fight for better education, even before they started school!

And here lies an even greater challenge: prosperity for all.  Prosperity defined not in the number of cars we own, but defined in our ability to properly feed, bathe, educate, and  raise our  children in a society that respects the dignity of man and the rights of the nuclear family to be together.

Sadly, we fail in many ways.  It pains me when I picture a mother bathing a baby tenderly, with much love who is not hers.  She is an OFW bathing the child of another mother while her own is being bathed by friends, neighbors, and relatives. This is a very painful picture.  I can only imagine how our society will look down the road when the effects of broken families will begin to creep into our labor sector, our government and corporate sectors. How will a citizen who hasn’t felt the nurturing warmth of a mother’s arms or the steady hand of father guiding his children survive?

This assault on the family is what we in the corporate sector should be concerned about. We all have different charities ranging from feeding the street children to providing roofs for the homeless. I believe however, that the simpler strategy is for all of us to focus in protecting our traditional, nuclear family.  The family should have the ability to feed, clothe, and provide basic education to their children. The children must not be deprived the warm bosom of their mother and the steady, guiding hand of their father.  Husbands and wives must be given the chance to freely express their love without the burden of having to define motherhood in terms of pesos and centavos.  Such definition is demeaning for our citizens, for our society.  The state fails when it has to intervene into how a family should express love and practice their faith in order to keep economic and social order. The state exists for me and not the other way around.  Common good defines that the state’s need should be subordinate to that of its citizens.

Corporate citizenship for me, therefore, should be about providing opportunities for the family as a whole.  For me, it is about encouraging and supporting opportunities for entrepreneurship, education, protection and enhancement of God’s gift of nature to us.  We have seen how corporate greed has destroyed homes, families, all over the world.  A secular world devoid of family values has made financial disasters happen.  We must reverse all these.

We must work hard to make our economy so vibrant that we do not have to ask our fathers and mothers to leave for abroad to work.  We must work hard to make this nation of entrepreneurs who create value for the society through creativity and innovation. We must work hard to create an economy that uses God’s gift to the enhancement of humanity’s survival with dignity.

THE CAPM AND RISK ALLOCATION

The CAPM is nothing more than a theory about how investors will behave when given an opportunity to do so. It theorizes that investors will invest in a stock or asset for as long its return is commensurate to the risk it has. This return and risk is benchmarked against the over-all return and risk of the entire market. If the return is too high against the risk, then an arbitrage situation occurs causing other investors to demand for that stock. This raises the price and consequently brings down the return.

This risk-return relationship is vital in any transaction. The allocation of the risks inherent in a transaction determines whether a contract is fair or appropriately priced. If a particular risk is given to a party that has no experience in dealing with the particular risk, then this party can price this risk so high that the entire transaction can become economically unattractive. It is therefore important to identify the risks properly and allocate to the proper party, and price the risk accordingly.

Let us take the case of a person buying a car. The price that one has to pay for the car includes an explicit guarantee from the car company saying that the car company will be responsible should the buyer find anything defective with the automobile within a defined time frame. This is only logical because otherwise, the buyer will have to conduct a technical due diligence on the car and determine for himself its technical soundness. The car in this case may be cheaper, but the buyer runs the risk of making a mistake in the technical analysis of the car.  There is no way for the buyer to know the condition of the car unless the buyer is an automotive engineer.

On the other hand, the car company cannot be responsible for the buyer’s driving habits. If a part breaks down because of bad driving, then the buyer is responsible, not the car company.  This is logical because there is no way for the car company to vet the driving habits of its buyers unless it does its own tests on its buyers.  This is a very expensive process, not to mention, an impractical one.

Thus, the car gets priced according to this risk allocation model of car buying – the car company is responsible for major breakdowns in case of normal wear and tear within a time frame, and the buyer is responsible for normal wear and tear.  Some brands price their products because of implicit and explicit guarantees of superior engine performance and track record. Others are priced lower with the appropriate lower guarantees of engine performance.

Buyers are then free to choose from European, American, Korean, Japanese, or recently Chinese automobile brands. Consumers choose according to their tastes and risk preferences.  Some consumers choose to buy more expensive brands while others buy lesser known brands knowingly that the car may breakdown more often than the better-known ones.

This transaction about a car is a practical application of the CAPM.  After the risks have been properly allocated between the buyer and the car company, then consumers choose the car according to their own risk preferences.  Those who want a cheap car take more performance risks than those who buy more expensive brands.  This is what the CAPM says: When the asset is priced properly, then no car in the market will be bought because of its lower price than the equivalent risk.

This means that if a four-cylinder Chinese brand car is priced at P100,000 and a similar engine displacement BMW car is priced at P100,000 also, then the demand for the BMW can go up so high and the car’s price will reach a level at which the demand will be satisfied. Let us say this price reaches P1,000,000.  So, two similar cars are priced vastly different – one is P100,000 and the other P1,000,000.

Which is more expensive?

Conventional wisdom will tell us that a P1,000,000 car is more expensive than a P100,000 one. Really? Having gone through the arguments of the CAPM and the risk allocation for the car transaction can you really say that one is “more expensive”than the other?

Setting aside the issue of affordability, the choice is really down to personal preferences. I may prefer the cheaper car even if I can afford the more expensive one because since I do not travel often, I do not expect the car to breakdown often.  On the other hand, I may prefer the more expensive one because I need to know my children are safe when I drive cross country with them.

In reality, there are no “expensive”or “cheap”assets since the asset is properly priced.  Such assets appear in the market occasionally. But if, in theory, the market is efficient, then consumers will see this as a bargain and the demand for the asset will drive this price up to its appropriate level. As we always say, we get what we pay for. In the case of hiring people, if you pay peanuts, then you get monkeys.

This leads me to a brief discussion on how this concept has an impact on government procurement. Again, conventional wisdom tells us that the government should always buy the “cheapest”product.  We hear of “overpricing”scandals almost everyday.  Having gone through the arguments of the CAPM, risk allocation and consumer preference; can we really say a product should be bought because it is “cheaper”than the other one?

Let us say, a hypothetical government agency bid out its requirement for a sedan. For example, the two car companies are Volvo and Cherry (both are Chinese-owned) and the results are as follows:

Chery              P 99,999.99

Volvo             P100,000.00

If you were buying the car for yourself, which one will you choose?

Chery Car. Photo from cheryinternational.com

Chery Car. Photo from cheryinternational.com

Volvo. Photo from netcarshow.com

Volvo. Photo from netcarshow.com

Why should the government decide any different?

For a small difference in price I can get a car that has a better safety record, a risk factor that is important to me as a father of a family.  Why shouldn’t the government care about its employees in the same way?

More importantly, from a finance perspective, the government will actually lose more value by choosing the “cheaper car”. The catch in this example is that most likely one or the other is wrongly priced. Assuming this is the case, the government will stand to gain more value from lower risk by buying the slightly more expensive car. Clearly, this is an arbitrage situation.

Unfortunately, the person making that decision i.e. buying the more “expensive”car can go to jail.  Government regulations will force the agency to choose the Chery over the Volvo. The government in that case lost value, but the agency head can retire with full pension and a clean record.

Clearly, the CAPM and risk allocation concepts can get lost in government, especially in a democratic government, particularly the Philippine government.  Before we get lost in this discussion, however, let me introduce one more important concept in Finance: portfolio theory. How all these concepts are intertwined and become important in the power sector will be seen soon enough.