A dark tale of private money in electricity

LTL - a subsidiary of the CEB - has mastered how to retain rewards while passing the risk

Budgets in Sri Lanka haven’t lacked ambition for social welfare spending for a number of reasons. First, no government wishes to waste the platform and media circus that follows the announcement of a fiscal plan. Since detailed outturns don’t attract much public interest, undeliverable promises can be made with impunity.

Even when the spotlight shines on them, poor budget outturns are dismissively explained as due to rising crude oil prices, adverse weather or other externality. That assumptions are a cornerstone of budget making is somehow lost. Without realistic assumptions, blindly optimistic government revenue projections are missed year after year.

When public finances are creaky, budgeted capital expenditure is slashed as a priority. That a critical new school building isn’t built is a bureaucratic detail unlike having unpaid teachers, a political liability.

In the last two decades, things have gone horribly wrong with Sri Lanka’s tax collections. This has had a shrivelling effect on the pot size for capital spending.

In 2015, tax collections as a percentage of GDP declined to 12% – lower than levels seen in most of Sub-Saharan Africa. The International Centre for Tax and Development estimated three years ago that the average tax takes in Sub-Saharan Africa had risen from 12% of GDP in 1990 to 15% by 2010. The turnaround in Sub-Saharan Africa is due to implementation of value added tax (VAT) and creation of autonomous tax agencies.

By the late nineties, however, it was apparent that linking public sector needs with private sector capital can be part of a solution to bridge the capital gap for infrastructure, freeing the anaemic tax take to fund upkeep of social infrastructure like schools, hospitals and rural roads.

A partnership with private sector capital fits in the middle of the spectrum of options for funding infrastructure, with state funding and privatisation on either side. Private sector capital funding public sector projects, sharing risks and returns, is widely used in the electricity generation and ports sector. These two are popular because they often generate revenue to not require government subsidies. Such deals are called Public Private Partnerships or PPPs. When done well, PPPs can address a number of shortages, but in bad deals it can have the opposite impact, as is the case in a power plant built as a PPP in 2010 by a privately held firm. Alarmingly, this company is now a frontrunner for another large power project.

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ri Lanka’s failing to implement a major electricity generating power plant since 2014, despite the demand rising eight percent annually, will cause a major electricity shortage by 2020. Tendering for a critical 300 megawatt power plant – equivalent to around eight percent of installed capacity – commenced in November 2016 but hasn’t yet been awarded. The bidder offering the lowest tariff, the most important criteria deciding a tender, is Lakdhanavi, a company where the monopoly power utility CEB has a controlling ownership (51% in this case) through LTL Holdings, also called Lanka Transformers.

However, there are three significant issues about awarding a critical power plant concession to Lakdhanavi and its owner LTL, all of which are centred on reducing risks. At the heart of all Public Private Partnerships is the concept of risk, to reduce the cost of capital and see cash, including from overseas, flooding into infrastructure. The greater the competition for PPP investment, the more value for money it delivers to citizens.

1It’s difficult to make risks disappear, but many, including unpredictable policy, meddlesome politicians, lawlessness and macroeconomic instability, can be improved. The first issue with Lakdhanavi being awarded a contract for a large and critical plant is the conflict of interest with its controlling shareholder being the monopoly power utility – the CEB.

LTL Holdings, the owning company of Lakdhanavi is bidding for the 300 MW LNG power plant to be located near the coast at Kerawalapitiya, a suburban area between the towns of Wattala and Kandana to the north of Colombo. Both LTL Holdings and its extension Lakdhanavi are CEB controlled by 63% ownership of the holding company, which in turn controls 82% of Lakdhanavi. Consolidated CEB financial statements will include all revenue, profits, assets, liabilities and equity of LTL Holdings and Lakdhanavi.

Up to 37% of LTL shares are held by employees, with three top managers controlling a 27% stake and the other 10% held in trust under their control. These three executives purchased the shares once held by ABB Norway though a management buyout of equity in a government company.

When done well, PPPs can address a number of shortages, but in bad deals it can have the opposite impact

Until recently, almost all of LTL’s business came from CEB tenders and contracts. This wouldn’t normally be a problem when product prices are low, orders are turned around quickly and it offers good value. However, a 20 year agreement for a critical 300 MW power plant burning heavy fuel to be later converted to LNG isn’t a typical tender for LTL.

Forty companies collected tender documents (Request for Proposal or RFP) for a process where the CEB influenced designing requirements, selecting the winner and contracting to buy electricity for 20 years at a tariff agreed at tendering. Should an LTL unit build the plant that would sell electricity to its own parent company?

Haste can bring problems. The RFP for the power plant was poorly designed. Three addendums were issued and some 850 pre-bid clarifications were required. The RFP also set a three month deadline for bids (against a typical seven months for a plant of this complexity).

However, 16 days before bids were due, the deadline was extended by two months. Any serious investor unable to fairly assess the risks of the project due to poor RFP design and without time to seek clarifications will likely have stayed away from bidding than expend thousands of dollars on professional fees to submit a hurried bid. Non-inclusion of an implementation agreement was also an issue. Such an agreement would have outlined the government’s commitment to underwrite illiquid CEB’s payment obligations to make the project bankable. Reversing the onerous financial qualification requirements just 21 days before the deadline was another problem. Many bidders had raised objections over both these matters. During bidding, the criteria for an EPC contractor qualification (engineering, procurement and construction) was reduced to one plant of 250-megawatts from two if he was a member of a consortium. Of the 40 potential investors that collected the RFP, only eight submitted bids.

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wo issues lie behind such missteps; one about capacity and the second more sinister. The first is a shortage of people in the public sector able to design, evaluate and supervise complex projects like a multi-fuel 300-megawatt power plant required in quick time to avert a crisis.

The second reason is rather dystopian. In a background where planning and design is weak, long-term infrastructure is often procured in a hurry. Special interests inside and outside the electricity utility have scuttled long-term planning leaving bureaucrats to play catch-up by rushing big projects. Facing a crisis, three fuel oil burning power plants were recently re-commissioned due to the electricity shortage. These include ACE Embilipitiya, a 100-megawatt private generator that was retired in 2015 (which  the electricity regulator PUCSL has so far refused to license). CEB subsidiary LTL has a long record of hiring ex-CEB staff. While arms length transactions can be maintained, secrets are difficult to keep in a group of companies linked by the past of shareholding, the present and the potential of the future.

Ultimately, procurements tailor-made for one company adds risks. As PPP programmes and contracts are complex to structure, manage and successfully execute, they are also rife for manipulation to suit just one favoured bidder. For successful PPPs, developing countries often engage global consultants to help draft frameworks and standard contracts (useful in some instances) and consult on individual projects. Multilateral lenders often finance such engagements though grant funding. However, no such expertise was available for the drafting of the Kerawalapitya RFP. The right procurement model depends on the individual project. However, the taxpayer bears the entire cost whether in bills, taxes, tolls or fares.

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 useful approach to PPP risk is to allocate it where it can be best managed. Negotiators of Sri Lanka’s most successful large PPP project aligned those risks well.

Although 16 potential investors expressed interest (were issued Request for Proposal/RFPs) to develop a narrow quay at the Colombo Port to a modern terminal, only a John Keells Holdings led combine submitted a bid, requesting a 50-year long terminal lease for an annual $2 million rental and offering a 7.5% shareholding to the government owned port manager, Sri Lanka Ports Authority (SLPA).

When the deal was signed, the government negotiating team had managed to reduce the lease term to 30 years, secured a royalty for every container handled at the facility and doubled the SLPA stake in the venture to 15%.

That container terminal is SAGT. Excluding the SLPA revenue from port services to ships calling at SAGT, revenue in 2016 from lease rentals, royalty and dividends stood at $14.05 million, which was close to the forecast revenue of $16.7 million made at the time the deal was concluded in 1999.

In the 16 years since 2000, SAGT’s contribution to the government (SLPA) in lease rentals, royalty and dividends was $182 million, just 9% short of the forecast $200 million for the period. These, however, are only part of the revenue the SLPA earns. Wharf handling, wharfage (for the use of the wharf) and navigation charges from ships calling at SAGT were forecast at $263 million for the 16 years to 2016. SLPA executives were unable to provide earnings from ships calling at SAGT, but the amount is likely higher than forecast at leasing the QEQ. This is because SAGT is handling way more capacity than the 1.1 million annual TEU it was designed for since construction on all three of its berths was completed in 2014.

One of the successes of the deal was allocating risks to where they can be best managed. The cost of private capital is high. However, private companies are better at building within budget, pushing operational costs down while keeping customers or users happy with better service. SAGT was built at a lower than budgeted cost, on time, and quickly won over new shipping lines to the Colombo port.

A decade later, Sri Lanka contracted LTL controlled Lakdhanavi to construct the 300-megawatt West Coast power plant – then costing $300 million. The 25-year PPA (Power Purchase Agreement) was a negotiated one.

A 2014 report commissioned by the electricity regulator observes the “costs are extremely high relative to other generators which were directly negotiated.”

Least cost and adequate risk transfer are straightforward aims of any PPP deal. However, in the case of West Coast power, located in Kerawalapitiya and where Lakdhanavi is a shareholder, neither has been achieved.

The initial investment for the plant came by way of a loan equivalent to $152 million arranged by HSBC and European and US export credit agencies, with the Sri Lanka government guaranteeing the loan. Instead of transferring some risk to the private sector, in this instance, the government bore the entire risk. The government had also intervened to secure more funding for the project – 2.9 billion rupees from the National Savings Bank and another 2.9 billion rupees from the Employees Provident Fund for the power plant, the first stage of which was commissioned in 2010. A research note by the private think tank Verite points out that Sri Lanka’s foreign loans act requires the government to hold at least a 50% share of any project where a loan guarantee is given. It reveals that the 50 % share of West Coast had been temporarily vested with the government on 14 separate occasions to fulfil the requirement for ownership at various times during the last decade or so.

Least cost and adequate risk transfer are straightforward aims of any PPP deal. However, in the case of West Coast power, neither has been achieved

At March 2018, the government owned half the shares of West Coast, LECO held 18.2%, and the EPF owned 27.1%, while Lakdhanavi had invested 4.8%.

Despite government ownership, no dividends were paid to the government. However, other Lakdhanavi shareholders LECO and EPF received dividends. Lakdhanavi, which owns 4.8% of the equity, received a disproportionate 39.7% of dividends. The EPF and LECO, which own 27% and 18%, received commensurate dividends during the years 2008 to 2016. (see chart 1)

Shareholders’ agreements had been structured to allow Lakdhanavi to receive disproportionate rewards. As a result, Lakdhanavi’s return on its Rs1.46 billion investment from 2008 to 2016 is 40% annually. LECO and EPF – which invested Rs2 billion and Rs2.9 billion – earned an annual return of 20% during the same period.

The shareholders agreement includes a clause requiring the government to transfer the 50% shares it owns to Lakdhanavi once the state guaranteed loan is paid off.

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etting PPP financial structures right, so that taxpayers, politicians and fund managers are all content, can be challenging. However, the first Lakdhanavi deal has demonstrated how easily private capital can be ruinous when not managed well.

A decade before the ruinous Lakdhanavi-West Coast deal, the government teams negotiated a remarkably successful 30-year port concession. Even if subsequent deals involve smelly compromises, repeating one as potentially disastrous as the Lakdhanavi-West Coast deal again will bury any credibility left of PPPs role in development.

Whole-life costing; asking concession seekers to put their money behind their forecasts brings rigour and discipline to the procurement process. If properly designed, the private sector’s higher cost of capital can be more than justified on the basis of risk transfer, efficiency, better service and risk management.

All these were achieved in the SAGT deal, while not even a semblance of these remains in the Lakdhanavi-West Coast project. To award a second such deal to the company that provided less than 5% of equity and 2% of financing but commandeered 40% of the rewards is ruinous. However, they are tantalizing close to such a deal.