www.IFC.org/ThoughtLeadership Note 21 | October 2016 ATTRACTING PRIVATE INVESTMENT THROUGH POWER SECTOR REFORMS Private sector investment is much needed in emerging markets to upgrade energy supplies, but too often power utilities in these markets are uncompetitive. In order to attract private investment, many aspects of how power utilities are operated need to be reformed. With their experience in helping to structure and finance successful infrastructure projects in emerging markets, development finance institutions are well positioned to support emerging market government efforts to translate power sector reforms into private investment. A stable, low-cost power supply is essential to attracting Magat Hydro Power Project investment in countries seeking to grow and industrialize. In the Philippines the poor financial condition of National Grid According to the International Energy Agency, additional Corporation, the state owned electricity utility, resulted in investment of about $900 billion is required between 2010 and unstable electricity and threatened the overall economy. 2030 to achieve universal electricity access. Around 40 percent of this additional investment would be in developing Asia. Moreover, the efficient non-oil electricity supply barely met the demands of the country. In response to those challenges the The public sector has traditionally provided 70 percent of total government launched a comprehensive reform to transform the infrastructure expenditures in emerging markets and has been electricity sector into a fully competitive and market-based central to the ownership, financing, and delivery of infrastructure system, including enactment in 2001 of the Electric Power services in these countries. But in the wake of the global financial Industry Reform Act. Additional sector reform came in 2006 with crisis government budgets have been squeezed and cannot the establishment of the Wholesale Electricity Spot Market, using shoulder the entire financing burden of infrastructure projects, a bid-based, energy-only, gross-pool model to help facilitate the especially in the long run. As a result, emerging market privatization of power plants. governments are beginning to seek private sector investment. As part of the reform program, the Magat Hydro Power Project The challenge to attracting private sector investment, however, is was privatized in December 2006 through an international tender that many public power utilities are highly uncompetitive. As a process. SN Aboitiz Power-Magat, a joint venture between SN result, several middle-income countries including India, Mexico, Colombia, Indonesia, and South Africa are reforming their energy Power of Norway and Aboitiz Equity Ventures of the Philippines, policies in order to stimulate private participation. As submitted the winning bid of $530 million.1 In October 2007, IFC demonstrated by the Magat Hydro Power Project in the disbursed a $105 million, 15-year loan to partially finance the Philippines and the Metro Power Company Limited Project in process. IFC, the anchor lender, was followed by the Nordic Pakistan, multilateral development banks are being encouraged to Investment Bank (NIB), which provided 15-year financing under improve economic management in the sector and boost the the same terms as that of IFC, and local banks, which provided a financial position of off-takers. Those reforms in turn will enable 10-year loan with a loan spread lower than IFC and NIB. development finance institutions to translate sectoral reforms into much needed long-term investment from both public and private Under the privatization scheme, the ownership of the Magat Dam investors through well-structured co-finance projects. and watershed remains with the National Irrigation Authority, while the project company, SN Aboitiz Power Inc., owns and MAGAT HYDRO POWER PROJECT: manages the generation facilities and dam under an operations and RISK MITIGANTS management agreement. The project is the first with significant Financial Risk Mitigants foreign investor participation under the 2001 reform legislation • IFC’s role as the anchor lender and provision of long-term that would operate as a purely merchant plant selling power in the 15-year loans with the NIB mitigated refinancing risk • When rainfall was low, the project sponsor bore the loss newly established spot market. The project instilled confidence in through refilling the debt service reserve account the privatization effort, accelerating previously stalled private • The IFC-structured investment secured other security interests to form a strong security package projects and creating a model for neighboring countries to follow. Construction/Operational Risk Mitigants  The IFC’s project appraisal, screening, and loan structuring Strength of the Project alleviated private investors’ concerns about complexities Even with low energy prices the Magat project was able to  Private sector participants bore dam safety related losses through insurance covering property damage and business achieve a strong financial performance because the National Grid interruption Corporation renegotiated the cost of ancillary services.  Private sector participants bore sedimentation related losses through the major maintenance reserve account, Meanwhile, the reputable and experienced project sponsors, business interruption insurance, and the debt service sound project fundamentals such as cost-competitiveness and reserve account peaking capacity, and the wholesale spot market’s track-record all Market/Off-taker Risk Mitigants contributed to the successful privatization and operation of the • Continuous dialogue with the government on the reform of Magat power plant. energy sector mitigated regulatory uncertainty • The conservative financial projection mitigated the risk of overestimating electricity prices The project was the first power privatization project with foreign • The strategy of mixing peso and dollar borrowing mitigated participation to be financed internationally in East Asia and foreign exchange risk created a model for the country. Fourteen successful power plant privatizations followed, of which 12 were processed without IFC’s participation during the period of 2007 to 2014. This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. -Owned Figure 2 Guarantees and Subsidies issued to State Enterprises 2011-12 Among all guarantees issued and all subsidies provided by the Pakistani government, the power sector absorbs by far the largest shares in both categories.3 Figures 1 and 2 provide a vivid Metro Power Company Limited Project illustration of the uncompetitive nature of the country’s power As part of the World Bank Group’s Pakistan Transformational sector, the reason that the public sector faces challenges in Energy Initiative, the Metro Power Company Limited Project providing the investments needed to provide sufficient power to aims to close the significant power gap in Pakistan by facilitating the population and business community. investment in incremental power generation based on low-cost indigenous resources. The overall project cost is $131 million, of IFC’s investment in the Metro Power Company Limited Project which IFC is financing $26 million through an A Loan worth provides additional power of 50 megawatts through a wind farm. $22.5 million and equity investment worth $3.25 million. IFC has also mobilized $22.5 million financing through a parallel loan. METRO POWER COMPANY LIMITED RISK MITIGANTS Pakistan has a large and growing power gap that in 2014 stood at Real risks: around seven gigawatts, or one-third of the summer peak demand • Financing and Project Development Risk: IFC provides both of 21 gigawatts. The persisting and recurring power outages that direct financing and support to bring in additional investors • Project Revenues Risk: Revenues are backstopped by a result from that gap present a tangible impediment to economic government guarantee. The specific project will sell growth in the country, as daily outages range from eight to 10 electricity to a state-owned off-taker under a 20-year energy hours in cities and 12 to 15 hours in rural areas. purchase agreement and the Pakistani government will guarantee payment obligations • Wind Risk: The government included a shortfall Public investment in additional capacity was close to zero from compensation mechanism to reduce specific sector risk 2000 to 2008. It was limited not only by fiscal constraints, but by • Foreign Exchange Rate Risk: Capital and operating costs in the tariffs are indexed the uncompetitive nature of the power industry in Pakistan, with significant fiscal resources spent on rising tariff subsidies on Systemic risks: • Regulatory Risk: If laws change, compensation offered by account of less than full cost recovery in consumer tariffs.2 the government could be affected • Macroeconomic Risk: Pakistan currently generates 39 percent of its electricity through imported oil, a needless drain on the country’s foreign reserves and terms of trade. Increasing renewable energy projects decreases its dependence of imported oil and also on oil overall, a tangible mitigant to climate change This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. That helps the project meet multiple goals of the World Bank The Magat project follows a new national power strategy that has Group’s power strategy in Pakistan and globally, including clarified roles of the government, of state-owned enterprises, and providing universal access to power as a means to inclusive of the private sector. Because many local parties also participated growth, increasing the share of renewable energy, and increasing in the project, local banks were also included and provided long- the participation of the private sector in power generation projects. term financing and local knowledge. How Risks Are Mitigated Conclusion Demonstrating the ability to correctly identify risks and to address Public utilities in emerging markets are often uncompetitive, them comprehensively is a major factor in convincing other creating a drag on economic growth and development. Public interested private sector investors to enter the power sector in sector reform, however, can create the enabling environment Pakistan. needed to attract much needed private sector investment to energy projects. IFC projects in the Philippines and Pakistan demonstrate Because the key participants were all experienced investors, the how development institutions can play a role in spurring reform focus of risk mitigation efforts was on real and systemic risks and bringing in private capital. rather than the perceived risks that often prevent less experienced Thomas Rehermann, Senior Strategy Officer, Office of the Chief investors from considering an investment. Economist – Thought Leadership (trehermann@ifc.org). Lin Shi, Strategy Analyst, Office of the Chief Economist – Thought Leadership (lshi1@ifc.org). 1 J. Virola, and T. Pamintuan, “Expanded Project Supervision Report 2012 on the 2 Sarwat Aftab and Sarmad Shaikh, Reforming State‑owned Enterprises, The World Magat Hydro Project,” International Finance Corporation of the World Bank Group. Bank, Pakistan Policy Note 4, 2013. 3 Aftab and Shaikh 2013. This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group.