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Audit Of Power Purchase Agreements

B.R. Mandal - SAI India

Introduction

In the developed countries demand of power has tapered off to around 2 to 2.5% as against 9% in the developing countries. Hence, there is a glut in the power equipment market. The independent power producers (IPPs) are, for obvious reason, interested in the low risk power generation sector and not in high risk transmission and distribution (T&D) sector. To negotiate with the financially strong IPPS, one needs to be equally strong and alert of the global market. In the absence of either any Memorandum Of Understanding (MOU) for buying power becomes one sided. Worst still is the "indicative bidding". Under such a situation, it is financially prudent to adopt competitive bidding or global bidding or price-based bidding instead of cost-based bidding . Cost plus formula plus MOU approach with payment on deemed generation could cripple, the financial position of the buyer of power (BOP). An Inevitable result is a hike in tariff. While auditing the Power Purchase Agreement (PPA), one needs to consider the following issues:

1. Power situation:    The overall power situation of a State vis-a vis the existing installed capacity, actual generation of power , actual delivery of power at the bus bar and T&D loss should be looked into. If the gap is narrow between the actual generation and the demand projection at the bus bar, it can possibly be met by upgrading the existing installed capacity or by increasing the capacity of the existing system by proper maintenance or by minimising the T&D loss.
2. Demand projection:    There may be wide variation between actual generation and the projected peak demand due to wrong assumptions in forecasting the demand projection, such as, low plant load factor (PLF). The demand projection might give a totally distorted picture if deterministic method, which does not take into account stochastic nature of demand, is adopted, as opposed to the probabilistic method. Hence, the question needs to be addressed as to what extent capacity addition would be necessary in view of the actual demand position in existence and the rise in future.
3. Generation and T&D:    The mere emphasis on (generation) capacity addition without any corresponding improvement/development of the T&D System has its own dangers. The two necessarily have to be dovetailed otherwise it will entail making payment for deemed generation to the IPPs.
4. Load option:    It is necessary to ascertain whether the demand for power is in base load or in peak load. To meet the peak load the plant has to be high-cost-fuel-fired as opposed to base load in which the operational cost is less. If, for meeting the peak load, increase in installed capacity of base load is selected, it will mean backing down of the generation from cheap mode in off-peak period. The base load power projects should ideally be based on the least cost option as they operate uninterrupted throughout the year barring plant shut down.
5. The Tariff:    There are basically two types of tariff in practice: one, Standard Tariff Model or Fixed Rate of Return Model or Two Part Tariff Model (as prevalent in India); the other is the Fixed Cost Model.

The Two Part Tariff is derived from the capital cost of the project and the cost of financing the project, and is essentially a cost plus approach which involves no risks for the IPPs. This approach encourages the IPPs to inflate their costs, as this would finally get translated into higher tariff This tariff prescribes certain per cent rate of return (ROE) on equity at certain per cent of PLF with additional incentives for each per cent point of additional PLF. In this type of tariff if the ROE is fixed at a low PLF, it will be advantageous for the IPPs as it is easier to achieve such low PLF with the present day technologically advanced power equipment. This will enable the IPPS to earn abnormally high incentive. The result will be earning higher ROE and higher internal rate of return (IRR). This means, any IPP with a high rate of ROE would recover its whole investment in much shorter time. Such a guaranteed ROE would also tempt the IPPs to inflate the capital cost of the project as it provides no incentive to minimise the fixed cost of the project. Though there is global recession in the cost of equipment of power plant, especially of the gas turbine, the reason for non-reduction of capital cost of the power plant is due to cost padding by the IPPS to avail of the exceptionally high built-in incentive.

In Fixed Tariff Model, the tariff is fixed at pre-determined capital cost. The Fixed Tariff Model as adopted by some IPPs is so designed that it gives an impression of the net tariff to be either equal to or less than the tariff arrived at by adopting Standard Tariff Model or Two-part Tariff Model. While the tariff looks fixed, in actuality it is not, as the elements of capacity payment and energy payment constituting the tariff are price indexed and price escalation-linked to the men-and-material (labour, material and tax incremental) in India and abroad. In a Fixed Tariff Model, tariff will increase year after year because of the in built escalation clause in the contract.

Main features of the PPA

The PPAs are complex documents. Depending on the negotiations BOP had with the IPPs, the conditionalities in the PPAs vary. Each PPA has its own peculiarities and specialties. But the main features, more or less, remain the same in all the PPAs.

A typical PPA may contain the following:

(1) Preamble, (2) Definitions and interpretation, (3) Conditions precedent, (4) Development stage, (5) Construction period, (6) Commissioning and entry into commercial service, (7) Plant operation, maintenance and fuel management, (8) Dedication of capacity, availability declaration, (9) Measurement of capacity, availability and energy metering, (10) Capacity charge and payment provisions, (11) Fuel Price provisions, (12) Billing procedures, terms of payment, (13) Insurance, (14) Changes in tax, changes in law, (15) Force Majeure, 6) Termination and buy out provisions, (17) Governing law/dispute resolution, (18) Liability and indemnity, (19) Confidentiality, (20) Representations/warranties/covenants and (21) Miscellaneous.

The PPAs also contain a number of schedules which may include the following:

(1) Description of Power Station, (2) Clearances, (3) Development milestones, (4) Interconnection and transmission facilities, (5) Commissioning and testing (6) Metering standards and testing, (7) Despatch procedures (8) Capacity payment and (9) Energy payments.

A.    General issues

We need to examine: (i) the total nameplate capacity contemplated in the agreement and the PLF guaranteed, (ii) whether the BOP has got enough infrastructure to evacuate the power, (iii) in case BOP undertakes to evacuate all power generated by the IPP, whether it will have to back down their own generation, and financial impact thereof and (iv) the terms and conditions of wheeling charges in case the power is to be sold to a third party due to BOP's inability to evacuate the power generated by the IPP.

Conditions Precedent could be many. The PPA does not become effective unless the conditions precedent to its effectiveness are fulfilled or waived by the parties, either mutually or by themselves in the manner provided in the PPA.

It is necessary to examine (i) terms and conditions of various issues under conditions precedent, with reference to power station site and fuel facility site, wayleaves for construction of pipe-lines, transmission lines, communication lines, harbour rights, various support agreements and project/construction contracts, on-shore power station contract, off-shore power station contract etc. and financial implication thereof.(ii) obligations and liabilities and financial implications on both the sides in fulfilling the conditions precedent, development stages and construction stage and (iii) the control mechanism specified in the PPA by the Government and the conditionalities of importing plant and machinery, fuel and any other material required for the project and their adequacy.

PPA specifies the type of power plant (whether combined cycle or open cycle), ambient temperature, atmospheric pressure and power output frequency at which the plant will operate in a particular locality. It specifies the plant installed capacity to be maintained in that ambient temperature, pressure and frequency. In the operating mode, it specifies installed base load capacity and installed peaking capacity. Some PPAs mention "Black Start" facility to achieve peak load

We should examine: (1) the feasibility of maintaining constant ambient temperature in a given environmental condition and achieving installed capacity as per contract and in case of failure by the IPPs whether any penalty clause is provided in the PPA. (ii) the station heat rate at which the plant will function. If this is lower than the rate prescribed by the Government, it will give rise to hidden benefits which should be determined to find out the actual return to the generating 'PP. (iii) base load capacity and peak load capacity envisaged in the power plant and how "peak capacity" will be achieved. If it is to be achieved by "black start" facility, it is necessary to examine the financial implications (iv) cost involved in base load capacity and peak load capacity and financial implications thereof (v) whether the technical parameter provides for alternative use of fuel for meeting base load demand and peak load demand, (vi) if use of alternate fuel is contemplated to meet base load demand and peak load demand, whether switching over from one type of fuel to the other type would need change of burner or can be controlled by electronic devices, (viii) if there are two phases, type of fuel to be used in the first phase and whether on completion of second phase, the whole plant will be converted into different type of fuel fired plant. If so, the financial implications thereof and (ix) if the contract is terminated on completion of first phase, financial implication in the use of fuel due to non- conversion of plant.

The cost of plant and machinery, construction cost, engineering cost, source of finance, terms of repayment of loan and equity participation etc. are the important issues; The terms and conditions for borrowing, whether rupee or dollar, and the debt-servicing thereof is decided by the 'PP based on the agreement entered into between the lender and the IPPs.

It is necessary to examine: (i) reasonability of the Project Cost arrived at .(ii) cost estimates in respect of land, plant & machinery, development cost including third party charges, spare parts and on-construction cost etc. (iii) debt-equity ratio including financing agreement in respect of loans, terms of repayment, proportion of foreign currency and domestic currency components of the loan, and debt-servicing in each category of loan and financial implications on the BOP. (iv) the equity

participation and the extent of BOP's share in the equity, (v) whether plant and machinery will be procured through competitive bidding or otherwise and whether BOP will be involved in such exercise.

The PPAs specify the type of fuel, i.e. distillate, gas, naphtha or coal that will be fired to produce power, method of procurement and location or source of the fuel to be used. The fuel could either be imported or indigenous. Cost of fuel is directly linked to escalation and any risk of exchange rate variation has to be borne by the BOP. The PPAs also provide "take or pay" clause and the LD Clause. In case the BOP is unable to accept all the power according to the despatch schedule and if the fuel procured by the IPP remains unused, the BOP will be required to either pay liquidated damages or pay the cost of the fuel not utilised for purposes of generation. Type of fuel to be used, their location and arrangements for procurement are crucial part of the PPA.

jt is necessarv to examine: (i) fuel contract executed, if any (ii) the kind of fuel proposed to be used in various phases (in case of more than one phase).If it is imported fuel, whether the option for indigenous fuel was explored before accepting imported fuel, (iii) whether any agency is appointed as fuel manager. If so, whether it is affiliated to the IPP and whether BOP will have to pay fuel management fee and justification for making such payment (iv) to what extent the BOP will have any say in fuel arrangement (v) the terms and conditions for import of fuel (vi) source of fuel and manner of fixing price (vii) implication of "take or pay" fuel and (viii) financial obligation in the event of fuel procured but not used.

Conditions are laid down for the commissioning of the plant, testing of base load and peak load, testing fees, commissioning charges, delivery of active energy and reactive power and liquidated damage in case of non-achievement of base load and peak load and modifications, repairs and improvement of the plant by the 'PP in the event of failures thereof.

We should examine: (i) the manner in which commissioning is proposed to be done (ii) condition of testing (iii) whether BOP has to pay commissioning and testing fees and also to pay for active power and reactive power generated and released to the BOP system during testing. If so, whether there is any financial implication (iv) the financial consequences in case of failure of the IPPs to achieve base load capacity and peak load capacity, and the reasonableness of grace period, if any, given to the IPPs and (v) the terms and conditions for post commercial service period.

While discussing the tariff earlier in details, we have mentioned that PPAs provide for payment of tariff in the form of capacity charge and energy charge. The PPA being "Take or pay" agreement, payment is to be made on created capacity or deemed generation of the plant and not on the basis of the actual delivery of the power to the BOP system. Installation of a plant of a specified capacity is left to the technical parameter worked out by the IPPs; hence, making payment on installed capacity does not appear to be sound. Secondly, having set up the plant, the IPPs are not prepared to take even normal business risk and in the event of BOP' 5 inability to take the power the IPPs would still be paid for. In case, however, BOP wants to avoid this situation and evacuate the power generated by IPPS, it would have to back down its own cheap mode of generation during off peak period and pay for power at high tariff rate. Fall out of all these would be unavoidable hike in tariff.

Besides type of tariff adopted, mode of calculation is complex. Various cost elements are taken into consideration for tariff calculation. Therefore, we need to examine: (i) the Mode of tariff adopted: Two Part Tariff or Fixed Tariff Model (ii) whether any of the aforesaid mode of tariff has been adopted with any modification (iii) whether Two-part tariff is modified to accommodate tariff adopted by the IPPs (iv) the rate at which incentive has been given (v) the elements of cost in Capacity Payment and in Energy Payment and assumption made in calculation of tariff (vi) formulae (generally in the Schedule of the PPA) adopted to calculate the Capacity Payment and Energy Payment to find out elements of price escalation due in labour and material (with dollar component and rupee component as the case may be), tax incremental charges and various elements that constitute the tariff (vii) ROE on equity contemplated and actual ROE accruing after including incentive and corresponding IRR (viii) justification for ROE and IRR allowed (ix) fixed costs, 0 & M costs and Variable costs contemplated in tariff and price escalation allowed therein (x) in case of Fixed Tariff Model adopted by the IPP, check up elements of cost and how the tariff is arrived at (xi) is the tariff really fixed or flexible due to escalation clause? If not, to what extent it varies and the combined effect would result in increase in tariff..

7.    Billing Procedure and Terms of Payment

It needs to be checked: (i) whether any cost data will be made available to the BOP (ii) in the event of failure of metering, how the charge will be decided (iii) the penalty contemplated in the event of failure of payment and nature of securities/guarantees obtained by IPPs to secure their payment (iv) whether there is any provision for inspection of meter. If so, the terms and conditions need to be checked.

All obligations and expenditure incurred on transmission lines together with ancillary switchgear, plant and equipment for the purpose of connecting the power station to the BOP system at the delivery point are not only to be constructed by the BOP at their cost but also designed by them. This cost could be too high for the BOP alone to bear.

It is necessary to scrutinise: (i) financial implications on the BOP (ii) if the BOP has to build up infrastructure to take delivery of the power to its systems, whether there will be any adjustment in tariff to absorb the, cost incurred by the BOP (iii) whether any cost adjustment is made towards the use of T & D lines of the BOP and T & D loss.

The PPAs stipulate various conditions in respect of operation, modification and maintenance of the power station generally and the nature of maintenance of the plant and machinery as well as parties engaged and the payment to such parties for carrying out operation and maintenance.

We need to check: (i) terms and conditions of operation and maintenance (ii) selection of agency to carry out maintenance of the plant and whether BOP has got any say in selection of such agency (iii) whether BOP has got any control on the expenditure incurred for operation and maintenance or in the nature and scope of maintenance.

There are several liquidated damage (LD) clauses in the PPAs. The LD clauses are applicable to developmental stage, construction stage and post-commercial entry of the power plant, fuel supply contract as well as intake of power created and generated by the IPPs. Both sides are contractually bound to pay LD equal to amount as specified in the PPA in the event of failures to fulfill contractual obligations and conditions.

Besides equitability of LD clauses, we should examine the quantum of damage fixed for both sides in the event of failure in respect of (1) the conditions precedent the developmental stages (ii) Developmental Stages (iii) Construction period (iv) Testing and Commissioning of the plant (v) Post entry into commercial service (vi) fuel and fuel management (vii) maintenance of Base load and Peak load (viii) payment of billed amounts.

11.    Force Majeure

There are various Force Majeure clauses. Force Majeure means any event or circumstances or a combination of circumstances laid down in the PPA which are beyond the reasonable control of the affected party and which the affected party could not have prevented by the good industry practice or by the reasonable skill and care in relation to the construction of any facilities, and which, or any consequences of which, have an effect on the performance by the either party in fulfilling its obligation or BOP '5 inability to receive Active Energy into its system at the delivery point. The Force Majeure could be Industry Force Majeure, Political Force Majeure, and Gas Force Majeure etc.

The Force Majeure clauses are provided to cover political risks, natural risks and industrial/operational risks. Both the jPPs and the lenders are worried and therefore tried to cover all possible risks with the result that the terms and conditions become, at times, one sided. It is necessary to examine the procedure, their applicability, financial liabilities arising out of it and to what extent they are equitable.

The PPAs provide for payment of insurance premium by the BOP involved at the construction stage, commissioning stage and in the post-commissioning stage. Such insurances are to include builders', 'all risk' insurance, comprehensive third party insurance, workers' compensations and insurance, against any loss or damage caused to plants and machinery in course of operation or in the event of (in some cases) political Force Majeure. But the claims settled by the insurance companies as a result of damage to the assets either at construction, commissioning or at post-commissioning stage is required to be paid to the 'PP who may apply the proceeds of such claim as it deems fit.

With this background in mind we need to examine: (1) the process of selection of the insurance company (ii) the basis on which the insurance premium is arrived at and whether it is kept flexible or fixed (iii) in the event of damage to the insured plant and machinery, who will receive the claim and how it will be accounted for and used and (iv) whether adequate safe-guard is provided to prevent double payment of the premium by the BOP.

The PPAs provide several tax exemption clause and tax incremental charges. They are provided to attract IPPs and to lessen the burden on tax payer for a certain period. One has to see the effect on tariff after the tax holiday period is over.

The following issues may be looked into: (i) the extent of tax exemption given to the IPPs and the tax incremental charges to be adjusted by the IPPs in calculation of tariff and (ii) whether the exemptions given are permissible under existing law of the land and (iii) if those exemptions are taken into calculation for tariff

The PPAs generally provide for construction of generation plants under the scheme of Build Own and Operate (BOO) and not under the scheme of Build Own & Transfer (BOT). Under BOT, there would be the express provision for the automatic transfer of assets at the end of the franchise period (i.e. contract period) which is absent in BOO.

Therefore, in absence of any express provision in the contract, at the end of franchise period renegotiation is required to be made for buying out which might involve greater risk financially.

We need to examine: (i) whether the termination clauses are on equal footing (ii) whether there is adequate safeguard for the BOP' 5 interest (iii) whether there is any clear cut provision for arriving at the cost of the plant & machinery at the end of the franchise period (iv) to what extent the BOO provision will protect the interest of the BOP in absence of such provisions.

The PPAs provide for dispute resolution through a Panel consisting of one or two high level representative(s) failing which through Arbitrators and Experts who are either Indian or foreigners and such disputes would be settled in a place either in India or abroad.

We should examine: (i) method of dispute resolution i.e. whether it is through Panel or Experts or Arbitrators (ii) if it is through panel, who nominates the panel and what control the BOP will have and what would be the financial implication (iii) if it is through Expert or Arbitrator, whether it there is any pre-agreed party (iv) the mode of selection of the party for arbitration and the Law of the country by which the arbitration process will be governed.

Other issues which need examination depending on the provisions in the PPAs could be as follows: (i) The tariff calculated by the IPP envisages repayment of debt and debt servicing in first 8 to 10 years (or any such period as the case may be) after they enter into commercial service. The tariff shows an upward trend even though the debt burden is completely wiped out. This, together with payment for deemed generation, would ultimately result in equity return at a much higher rate than the percentage projected by some IPPs in the Fixed Tariff Model, (ii) If the norm of the debt equity ratio is prescribed by the Government, we should examine whether it has been maintained or not. (iii) The investment plan and borrowing details should be examined to assess the interest burden on the project, (iv) There could be various concessions in acquisition of land, non-levy of certain taxes, water supply, electricity supply and customs duty etc. These needs thorough examination, (v) In many cases BOPs have appointed foreign merchant bankers as financial advisors to help them in finalising the PPAs. The mode of selection, the terms and conditions and the fees payable to such merchant bankers should also be scrutinised and may be commented upon if necessary.