Power Sector 2010

8/6/2019 Power Sector 2010

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Re s ea r c h ed & Wr i t t e n B y :

F P JeromeCPA, ACMA (UK)

Manager Head of Ratings(94) 11 2553089

[email protected]

Com pany Con tac t :

Adrian PereraMBA, FCMA (UK), FCCA, FCMA, MCPM, AIB

Chief Executive Officer(94) 11 2596099

[email protected]

Ana lys t Con t ac t :

Prashani IllangasekeraM.Sc., B.A.

Senior Analyst(94) 11 2503551

[email protected]

We b s i t e : w w w. r a m . c o m . l k
mailto:[email protected]:[email protected]:[email protected]://www.ram.com.lk/http://www.ram.com.lk/mailto:[email protected]:[email protected]:[email protected]


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RAM Ratings (Lanka) Ltd

Summary

In line with its brightening economic prospects, Sri Lanka is geared to narrow thepower deficit which has been prevalent over the last few decades. By 2008, thecountry had achieved 80% electrification; as per the national energy policy, thegovernment intends to raise this to 95% by 2015 (with a mix of grid extensions andoff-grid solutions).

Over the past 15 years, the country has been gradually shifting its energy mix fromhydro to thermal power. According to the Ceylon Electricity Boards (CEB) long-term plan for the sector, the island nation will continue depending on thermalsources, favoring coal-based rather than fossil fuels. Meanwhile, non-conventionalrenewable energy sources (NCRES) - such as biomass, wind and solar energy - areexpected to supplement the countrys power requirements.

The power sector has been opened up to independent power producers (IPPs),which has in turn assisted the state utility in meeting the nations rising demand.That said, the state is expected to retain its dominance in power generation over thelong term, as per the Sri Lanka Electricity Act of 2009. The Act requires that anyplant with more than a 25-MW capacity be ultimately controlled by the government.

On a related note, increased reliance on imported fossil fuels and the challengesfaced by the state utility in implementing its long-term plans have pushed up tariff rates. A crucial consideration for any IPP is the rate of its electricity tariff. In thisregard, the industrys standardized power-purchase agreements (PPAs) have alsoevolved from an avoided cost basis (premised on the marginal cost that the CEBwould have had to expend to generate power) to a more cost-reflective structure.Perhaps the most positive aspect of this switch is that existing IPPs have the optionof continuing with their original PPAs. RAM Ratings Lanka considers this feature tobe critical as investor confidence in PPAs remains intact.

In addition, we note that more IPPs are likely to be attracted to the power sectorgiven its salient features such as stable demand, moderate operating risks and longlife of assets. From a credit-rating perspective, however, we have identified severalinherent risks that include construction risk, fuel-supply risk and customer-concentration risk. Construction risk involves the companys possible failure tocomplete construction on time; fuel risk is primarily based on possible interruptionsin fuel supply. Meanwhile, customer-concentration risk is inherent to the industry asthe CEB is the sole purchaser of power.


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Background

The power sector is a pivotal component of any economy. This sector driveseconomic activity and development literally and figuratively. Likewise, the SriLankan economy also hinges on the power industry (refer to Chart 1). However,demand has been outstripping supply, increasing 7% to 8% annually; the domesticpower sector has been struggling to meet the expanding demand for electricitythrough the late 1980s, 1990s and the first 2 years of the new millennium 1. Notsurprisingly, this industry has become a hot topic for debate.

Chart 1: Growth in economy and el ectricity consumption

19 97 1 99 8 1 99 9 20 00 20 01 2 00 2 2 00 3 20 04 20 05 2 0 06 2 00 7 2 008

D eman d fo r e lec tric ity1 2 .5 7 % 11 .9 3 % 6 .3 7 % 9 .3 6 % -0 .4 0 % 5 .0 4 % 1 2 . 83 % 7 .3 8 % 8 .8 2 % 7 .9 6 % 5 .6 7 % 1

GD P 6 .3 0 % 4 .7 0 % 4 .3 0 % 6 .0 0 % -1 .5 % 4 .0 % 6 .0 0 % 5 .4 0 % 6 .2 0 % 7 .7 0 % 6 .8 0 % 6 .0

-4.0 0%

-2.0 0%

0.0 0%

2.0 0%

4.0 0%

6.0 0%

8.0 0%

1 0.00%

1 2.00%

1 4.00%

% G r o w t h

Source: Economic and Social Statistics of Sri Lanka 2009 - Central Bank publication (2008 numbers areprovisional)

The local power sector is presently dominated by the CEB - the sole entity with theright to generate, transmit and distribute power (vertically integrated). The statescontrol is likely to continue through the Sri Lanka Electricity Act of 2009.

1 Sri Lanka Country Assistance Programme Evaluation: Power Sector - ADB 2007


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Histor y of the CEB

The CEB had been formed under the Electricity Act No. 19 of 1950 and the CeylonElectricity Board Act No. 17 of 1969. Nonetheless, the history of the domestic powersector dates back to 1895; the first commercial distribution system had been withinColombo. However, the sector had been transferred to the state following theestablishment of a separate department in 1926, which was later renamed as theDepartment of Government Electricity Undertakings (DGEU). The local authoritiesand licensees had been responsible for distribution and supply while the DGEU hadbeen tasked with the generation and transmission of electricity.

In 1969, the functions of the DGEU were transferred to the CEB, thus making thelatter responsible for the generation, transmission and distribution of electricity.However, some local authorities had still seen to the distribution. Recognising theinefficiencies of the CEB, the state formed Lanka Electricity Company Limited(LECO) in 1983. LECO is co-owned by the Treasury, the CEB, local authorities andthe urban development authority. By 1992, the CEB had substantially completed theacquisition of the remaining distribution schemes operated by the local authorities.

Meanwhile, the countrys power-generation industry had been wholly reliant onhydro sources. In 1986, as much as 99.7% of Sri Lankas electricity requirementswere fulfilled by hydro power. However, this dependency had rendered the sectorvulnerable to fluctuations in rainfall. In the interest of speedy capacityaugmentation, the CEB had diversified into fossil fuels to generate power, with agradual shift in the industry power mix (refer to Chart 2).

Chart 2: Trend in pow er mix

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Hydro 19% 19% 28% 30% 32% 35% 39% 39% 44% 44% 46% 46% 46% 49%

Thermal 81% 81% 72% 70% 68% 65% 61% 61% 56% 55% 54% 54% 54% 51%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

P o w e r m i x

Source: Economic and So cial Statistics of Sri Lanka 2009 - Central Bank publication (2008 numbers areprovisional)

According to the CEBs long-term generation plans, more than 88% of the countrys

energy mix will be spearheaded by coal (refer to table 2). However, it should benoted that the implementation of these plans is critical to avert another energy


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crisis. If the CEB is able to successfully execute its strategy, dependence onhydroelectricity is likely to recede to 19.82% by 2022. Sri Lankas large reserves of hydro power have already been exhausted; hence only small NCRES power plantsare anticipated in the future.

Table 2: Capacity expansion by plant type

MW %Hydro 150 150 4.20%Combined Cycles 270 270 7.55%Coal 285 1670 1200 3155 88.25%Total 705 1670 1200 3575 100.00%

Type of PlantTotal capacity addition2009- 2012

(MW)2013- 2017

(MW)2018- 2022

(MW)

Source: Long-term Generation Expansion Plan 2009-2022

New Energy Sources

Hydro power, wind energy, biomass, solar power and municipal solid waste arepotential energy sources for Sri Lanka. Although these NCRES are only expected tosupplement the power needs of the country, this sector is likely to be dominated byIPPs. As mentioned earlier, Sri Lanka has almost exhausted its large hydro-powerreserves. Apart from the 150-MW upper Kotmale hydro-power plant, future hydrosources are more likely to be small or mini hydro plants using the run of the river design. As such, this does not require the construction of a dam. Instead, water isdiverted downwards from an elevation, thus creating pressure that spins theturbines to produce electrical energy.

Meanwhile, wind power is another option for Sri Lanka. The United States NationalRenewable Energy Laboratory (NREL) has confirmed that the island nation hasmany areas envisaged to have good wind resources. These lie in the north-westerncoastal region, from the Kalpitiya peninsula to Mannar island, and the Jaffnapeninsula and the central highlands. As per the NRELs estimates, about 5,000 sqkm of potential wind resources exist in Sri Lanka. According to the CEB, letters of intention for 64 MW of wind power had been issued as of December 2008.

Another alternative NCRES is wood. At present, there are 2 such plants (i.e. 35 kWand 1 MW) in the country, operated by Lakdhanavi (Pvt) Ltd. As at end-December2008, the CEB had issued a letter of intent (LOIs) for a 61 MW wood-poweredplant.

Solar energy, although another option, is still deemed too expensive. That said,solar-powered energy could become viable as part of an off-grid power system thatsupplies remote areas. Under the programme on renewable energy for ruraleconomic development (RERED), solar energy panels are given to ruralhouseholds. Through this scheme, certain financial institutions (participating creditinstitutions) provide 80% refinancing facilities on loans extended to qualifyingborrowers.

A further option for Sri Lanka is to use solid waste. As at end-December 2008, theCEB had signed a Standardized Power Purchase Agreement (SPPA) with 2developers, to establish 2.5-MW and 9.8-MW plants. In addition, an LOI has been

issued for another 143 MW plant. These projects have got off the ground.


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Sectoral Pow er Sales

Electricity sales - in giga-watt hours (GWh) mostly stem from the domestic andindustrial segments. That said, domestic sales have been rising in line with thecountrys increased electrification, although the pace of expansion has deceleratedafter the tariff hikes in 2008 (refer to Chart 3). With the end of the 3-decade-longcivil conflict and the upcoming coal-powered plants, however, overall tariff rates areexpected to fall. Should a downtrend in tariffs materialize, RAM Ratings Lankaenvisages demand from the industrial segment to pick up.

Chart 3: Trends in sectoral sales

2003 2004 2005 2006 2007 2008

Street light 1.71% 1.62% 1.50% 1.61% 1.64% 1.59%

General purpose and hotel 19.79% 20.17% 20.81% 21.56% 23.44% 24.31%

Industrial 38.77% 37.98% 37.31% 36.82% 35.17% 34.89%

Domestic and religious 39.73% 40.23% 40.39% 40.01% 39.74% 39.22%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% C

o m p o s i t i o n

Source: Central annual reports

Regulation of the Pow er Sector

The Public Utilities Commission of Sri Lanka (PUCSL) was set up in 2002, toregulate infrastructure industries, including the power sector. In March 2009, thecommissions powers were enhanced with the passage of the Sri Lanka ElectricityAct (the Act). This allows the PUCSL to exercise licensing powers and regulatetariffs as well as the safety and technical aspects of the generation, transmission,distribution, supply and use of electricity.

As per the Act, only state or public institutions will be eligible for licences vis--visgenerating electricity. Meanwhile, private-sector participants can obtain licences togenerate electricity so long as the plants capacity is less than 25 MW. IPPs havebeen allowed to venture into the industry since 1996. As a result, privateparticipation has been increasing, accounting for as much as a third of the sectorsinstalled capacity as at end-2008. In tandem with this, the IPPs contribution to thenational grid has also been augmenting. As at end-2008, IPPs fulfilled as much as


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40.92% of the industrys total power demand (refer to Chart 4). In view of the Act,however, private participation is likely to recede in terms of installed capacity.

Chart 4: Pow er-generation mix between the CEB and IP Ps over the past 13 years

1 995 1996 1 997 1998 19 99 20 00 2001 200 2 2003 200 4 200 5 2 006 2007 2008

IPPs 0% 0% 0% 7% 9% 15% 20% 2 3% 25% 38 % 39% 3 7% 39 % 4 1%

CE B 100% 1 00% 100% 9 3% 91% 85% 80% 7 7% 75% 62 % 61% 6 3% 61 % 5 9%

0 %

10 %20 %

30 %

40 %

50 %

60 %

70 %

80 %

90 %

100%

U n i t s G e n e r a t e d ( G W h )


Currently, the IPP sub-segment is also dependent on thermal generators to produceelectricity; the remaining 16% rely on hydro sources (refer to Table 2). Within the

thermal segment, the majority of IPPs use fossil-fuel-based technology to deliverpower.

Table 2: IP P capacity and pow er-generation mix over the past 12 years

Year

Private-Hydro in

MW

Private-Thermal

in MW

Private-Hydro %

Private-Thermal %

Private-Hydro in

MW

Private-Thermal

in MW

Private-Hydro %

Private-Thermal %

1996 1 100% 0% 3 0 100% 0%1997 2 31 6% 94% 4 13 24% 76%1998 2 92 2% 98% 6 390 2% 98%1999 6 92 6% 94% 18 507 3% 97%2000 12 174 6% 94% 43 917 4% 96%2001 24 174 12% 88% 65 1170 5% 95%2002 34 193 15% 85% 103 1248 8% `2003 40 355 10% 90% 120 1711 7% 93%2004 73 452 14% 86% 206 3064 6% 94%2005 84 567 13% 87% 277 3152 8% 92%2006 107 567 16% 84% 345 3082 10% 90%2007 117 567 17% 83% 344 3424 9% 91%2008 137 737 16% 84% 428 3579 11% 89%

Units Generated in GWhCapacity in MW



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Construction Risk

An IPPs revenue risk only comes in after the plants construction has beencompleted and it has been commissioned. Failure to complete on time can lead tocashflow deficiencies; under the PPA, the IPP failing to achieve the agreedmilestones can be construed as a default. The construction phase invariably posesthe single largest risk; credit-rating agencies only upgrade an IPPs rating uponelimination of this risk. In Sri Lanka, the lack of long-term funding sources has led topromoters seeking banking lines. Banks, in turn, either grant funding based on thecollateral or benefits from international agencies refinancing programmes.

Pow er P urchase Agreement

The PPA, which underscores the viability and attractiveness of the power project, isthe most important contract supporting an IPPs creditworthiness. RAM RatingsLanka reviews the PPA to identify potential loopholes in the contract that may have anegative impact on the projects ability to generate revenue, and ultimately affect itscredit rating. Areas of focus include tariff structure, termination events,compensation and force majeure .

Tariff rates are an important subject within the sector, given that Sri Lankas rates

are among the highest in the region (refer to Table 3). So much so that industrieswhich consume a lot of energy have claimed that they have lost or are losingcompetitiveness in the global market.


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Table 3: Comparative prices of electricity by type of user (as of 1 J anuary 2007)

Source: ADB Sector Paper - Sri Lanka Country Assistance Programme Evaluation: Power Sector, August 2007

There have been various tariff structures, i.e. thermal-powered plants tariffs can bebased on 2 components - capacity and energy charges. The capacity chargeconstitutes of escalable and non-escalable components. The non-escalable modulepartially addresses the shareholders returns and debt-servicing obligations. Theescalable component covers all administration and fixed operation and maintenance(O&M) costs as well as related expenses. Meanwhile, the energy charge is basedon the actual units produced (refer to the diagram below). This pricing methodologyhas, however, come under criticism, especially during the escalating oil priceswitnessed in 2008.


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In the meantime, the tariff rates of small power producers have changed from the avoided cost principle to a cost-reflective one. All IPPs with less than 10 MW of capacity come under the small power producer category in Sri Lanka; small powerproducers signing PPAs from 1 January 2008 onwards will have cost-based,technology-specific and 3-tiered contracts. Previously, the contracts had been basedon the avoided cost principle (i.e. the marginal cost that the CEB would have hadto expend to generate power). IPPs that had signed their PPAs before 1 January2008 will have the discretion of either abiding by the agreed tariff or switching to thecurrent structure.

RAM Ratings Lanka is also cognisant of the states role in adhering to the spirit of the PPAs, as there are political implications. In China, PPAs have been subject to re-negotiations and numerous tariff reductions. In the Philippines, the government hasbeen under public pressure to revise IPP tariffs. During the Asian financial crisis of the late 1990s, the Philippines state-owned electricity companies had found

themselves in deep financial trouble in honouring the PPAs with IPPs, mostly withthe take-or-pay clauses under which they had to pay for electricity no longer neededdue to the steep economic contraction.

As payments to many of IPPs had been denominated in US dollars while theelectricity companies revenue had been in local currencies, this had led toskyrocketing debts for the electricity companies due to the sharp depreciation of thelocal currencies. For example, the exchange rate for the Indonesian rupiah had shotup from 2,450 to 10,000 per USD; the electricity tariff would have had to increase70% to reach its pre-crisis level. Electricity companies had seen no other option butto pass on the cost increases to consumers, but this could not have come at a worsetime. The rate hikes had triggered extremely negative public reaction and stirred

political turmoil in these countries. Under enormous pressure from both the publicand the electricity companies, the governments had chosen to renegotiate the termsof the IPPs PPAs.

Although the experience in the Philippines had been instigated by external shocks, itnevertheless highlights the political repercussions that could ensue. In particular,restoring the financial viability of the off-taker is of utmost importance.

Fuel-Supply Risk

Fuel-supply risk is assessed by reviewing the arrangement between the IPP and its

fuel supplier. In Sri Lanka, all fuel-supply agreements are with state-owned CeylonPetroleum Corporation. Fuel cost is by far the largest operating expense of a powerplant. Again, the PPA becomes a focus point here as well as in determining marketrisk, if any. Meanwhile, RAM Ratings Lanka also evaluates the risk of fuel supply notbeing available to fire the power plant. Understanding the suppliers procurementand delivery processes is also important in order to assess the certainty of the IPPsfuel supply. On this note, some comfort can be derived from the existence of on-sitefuel storage as a back-up in the event of any supply interruption.


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Operating Risk

An IPPs ability to generate revenue is imperative to supporting its debt payments.The revenues of small NCREs producers depend on the actual volume of electricitygenerated. On the other hand, other PPAs may include a minimum guaranteedamount of energy. In the context of hydro-powered projects, the site and design of the plant are also critical towards achieving optimal capacity. RAM Ratings Lankasconservative benchmark for plant factor (or utilization ratio) is 60%; in Sri Lanka,few hydro-powered plants achieve this minimum threshold.

Apart from plants capacity factor, the experience of the operator is assessed. Ininstances where the operator is new to the industry, it would be essential to havetechnical tie-ups with established operators or some form of technical support fromturbine manufacturers during the initial years of operations. This is especially so if newer technology is used. The financial strength of the operator is also critical tosupporting its obligations under the O&M agreements. On a related note, RAMRatings Lanka takes into consideration the track record of the facilitys technical staff as there is a dearth of qualified experienced technical personnel.

Elsewhere, we also review the terms and conditions of the operations andmaintenance agreements. The performance guarantees and the plants related heatrates, availability and capacity should match the requirements under the PPA. Theduration of the guarantee is also important as a favourable performance during theinitial years of operation may not be a reliable indicator of the facilitys long-termshowing. The compensation payable to the IPP in the event of the operators under-performance is another avenue for transfer of risk.

Customer-Concentration Risk

In Sri Lanka, the CEB is the sole off-taker; hence the IPPs debt-servicing aptitudedepends on the off-takers willingness and ability to pay its bills on time. As such,the rating of an IPP cannot exceed the rating of the off-taker. In this regard, RAMRatings Lankas assessment of the CEB is based more on its systemic importancerather than its financial profile. In 2008, the state utility companys losses came upto LKR 35 2 billion, with LKR 57 billion owed to the IPPs. In the first half of 2009, theCEB incurred another LKR 9.3 3 billion of losses.

Funding StructureAn IPPs stable revenue, underpinned by its long-term PPA and a steady businessfocus, renders it a good candidate for project financing. Its capital structure is animportant consideration in credit rating; too much debt or an extremely aggressivedebt-repayment schedule can expose project lenders to significant risks. RAMRatings Lanka believes that a high level of owners equity serves as a strongincentive for the promoters to ensure that the project is viable, and minimizes therisk of abandonment should problems arise.

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Central Bank of Sri Lanka Annual Report 20083 Recent Economic Developments and Highlights of 2009 and Prospects for 2010 - Central Bankpublication.


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An operating IPP with a proven and stable cash-generating ability could take onadditional debt without too many negative implications on its rating if its debt-servicing aptitude is not compromised. In addition, the cost-reflective tariff structurealso lends support to the IPPs debt-servicing ability. Conversely, more equitycontribution and a lower debt level can lead to better a better debt-servicing abilityand higher ratings; the magnitude of elevation will be limited by the entitysbusiness risks.

Prospects

While Sri Lanka may have closed its door to large-scale IPPs, it has embraced therole of IPPs in the less than 25 MW capacity segment. In particular, the NCRESsector is likely to welcome new players. In bringing about these changes, the SriLankan power sector has successfully averted disruptions to the existing PPAs. That

said, the experience of China and the Philippines highlights the challenges thatgovernments face vis--vis adhering to the terms and conditions of PPAs. Bytranslation, this also underlines the importance of restoring the long-term financialviability of the CEB.


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Published by RAM Ratings (Lanka) LtdReproduction or transmission in any form is prohibited except by

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Power Sector 2010

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