How to handle our circular debt

The government has lately been trying to tackle the growing circular debt in the power sector. The policy thrust has largely been administrative. It has involved power cuts in the low-recovery areas and raises in the electricity prices to recover the costs. This hasn’t produced any tangible results.

On one hand, the government plans to float a Rs200bn Sukuk to settle part of the debt and, on the other, it has announced a freeze on electricity prices till June. This is not a wholesome policy as both the Sukuk and price freeze will only add to the debt stock.

More than anything else, the lack of understanding of linkages between the financial markets and the power sector has led us into this rabbit hole. A failure or arrested development in one market leads to a catastrophe in another. Circular debt is not primarily a power sector issue. The seed of the problem was sown somewhere else.

Of the approximately Rs1.8tn, the going circular debt figure, about Rs1tn is payable to the power sector, including the IPPs. The exact size of the debt is still not clear as various government entities keep fighting over it publicly.

Circular debt itself has been exacerbated by an addition of about 13,000 MW of new generation over the last few years, increasing the system capacity by nearly 50pc. IPPs’ major costs – fuel and return on equity and foreign debt – are indexed to US dollar but are payable in rupees. The rupee in the meantime has lost about half of its value. This has resulted in a significant increase in rupee payables.

As fresh capacity came on line, the economy tanked. Interest rates spiked, setting the stage for a perfect storm. In short, circular debt is ‘sourced’ by ‘expensive’ power and aggravated by inefficient Discos’ transmission and distribution losses, theft and poor recoveries. The electricity is ‘expensive’. Let us see why?

It is the failure of the financial markets/banks that has made electricity expensive. This is the rub. An asset like an IPP, which is supposed to supply electricity for 25-30 years under contract with the purchaser, is being forced to pay 75 percent of its costs in 10 years. No asset can meet this kind of front-loaded cash demand without causing serious spillover effects in the wider economy.

Consider a recent renewable IPP which has been awarded a levelised tariff of Rs5.6628/unit with tariff for first 10 years set at Rs7.234/unit and for the next 15 years at Rs2.3708/unit. The project’s debt tenor is 10 years. If the debt tenor is raised to 20 years, the tariff, ceteris paribus, for the first 10 years of the life of the IPP will come down from Rs7.234/unit to approximately Rs5.50/unit, or roughly by 24pc. Of course, the tariff for the remaining 10 years will go up.

This debt tenor stretching spreads costs over a greater number of years, curing the super-expensive power during the first 10 years and super-cheap power later. This tariff realignment making power cheaper by about a quarter in the first 10 years is exactly the headroom needed for the power sector. Exactly the reverse has been happening.

The trouble is longer debt tenors are not available locally – they are the norm globally though – and are only now being insisted upon by the Nepra. Even the SBP doesn’t lend for more than 10 years for renewable IPPs. Armed with this insight we can find a market-based solution to this market failure.

The only way, thus, to settle the circular debt is to roll it up for another 10 years and recharge it to the consumers during that tenor. The government need not nationalize this debt. It may issue bonds worth Rs1tn with a maturity of 10 years, which will then be paid off by consumers through a per unit charge on electricity procured over the same period. The bond will be amortized through quarterly payments over the number of units procured by the CPPA-G. During July 2018-June 2019, the CPPA-G bought 119,301GWh at a monthly average of 9,941Gwh. A 10-year amortization charge for Rs1tn at an interest rate of 15.5pc, over 9,941Gwh/month translates into a charge of Rs1.66/unit for ten years.

It is not that dark. High interest rates will come down, diminishing the charge/unit. This charge shall further diminish with time as the number of units procured by the central power purchasing authority (CPPA-G) go up, increasing the denominator. Over time inflation will eat it away, all the same. This bond is but an attempt at restoration of IPPs’ original debt tenor of about 10 years to a logical tenor of, say, 20 years to clear the backlog and “reduce the current cash acquisition cost.” To borrow a metaphor from the current Covid-19 crusade, we are just trying “to flatten the curve.”

This bond is a kind of tax bond to be settled by specific receipts from a specific levy for a given tenor. The government can backstop this bond by its zero-coupon PIBs, should the CPPA-G fail to settle these liabilities from this levy. There will be no net addition to government liabilities as it is already liable under the IAs. This bond, a one-off payout, however, will unblock the sector’s aorta for only now. Fresh circular debt, however, will still be created. How do we handle that?

Though the temptation is strong, the government must not reopen the PPAs and financing agreements, except, may be, in case of nuclear plants. It will be easier to sell new bonds to lenders. It will be less chaotic and it will not stymie fresh term lending.

To pre-empt future circular debt, the government must issue similar bonds for about Rs 300 billion each year for the next 3-4 years with similar terms “to flatten the curve.” The Nepra must insist on debt terms longer than 15 years at least, as it now has the ‘excess-capacity’ stick to beat the potential investors with. But the most important player is the SBP. One wonders what it will do, if anything, to create long-dated bonds.

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