Creating Bankable Regional Electric Companies
James M. Hogan, Managing Consultant, PA Government Services, Inc.
James M. Hogan serves as resident advisor for the Central Asia Natural Resources Management Programme (NRMP), which is part of an ongoing USAID initiative to improve the management of critical natural resources in Central Asia. For additional information please contact the NRMP office in Almaty or visit the NRMP website at www.nrmp.uz.
(The views expressed herein are the author’s own view and do not necessarily reflect those of the author’s employer or especially those of the United States Agency for International Development or the United States Government.)
Huge amounts of capital-mostly with mid- to long-term durations-will be needed to renew and expand Kazakhstan’s electricity distribution electric network. At present, however, it is difficult for privatized regional electric companies (RECs) to get loans1 under existing tariffs. Quite simply, tariffs are not high enough to support adequate borrowing. (In Kazakhstan’s rapidly maturing financial sector, commercial bank loans typically have short terms, mostly one year, sometimes up to three. The availability, structure and terms of loans in Kazakhstan for the electric distribution sub-sector are not examined in this article.) As a result, privatized RECs must fund their investment plans from operational cash flow?a severe problem for a capital-intensive business like the power sector. The inability to borrow will be especially burdensome if, as some experts estimate, half the electricity distribution network needs to be rehabilitated.
RECs must be able to borrow in order to make the investments needed to maintain service quality and expand the electricity network. Thus, RECs must become “bankable” companies able to borrow funds on commercial terms and conditions at reasonable cost and without government guarantees.
Recently, the Government of the Republic of Kazakhstan (GoK) developed a new tariff-setting policy that is intended to facilitate mid-term investment by natural monopoly companies. The Agency for the Regulation of Natural Monopolies and the Protection of Competition (the ARNM) will play a pivotal role because it has broad discretion to interpret the mid-term tariff policy. The reality is that the way the new policy is implemented could either accelerate or slow the pace of electric power sector reform and, in turn, affect the planned privatization of the country’s RECs as well as the introduction of competition at the retail level-all stated objectives of the GoK.
This article examines the new tariff policy, discusses some pros and cons, and explains its unique importance today. It concludes that the ARNM should focus on the reasonableness of the overall result of its tariff-setting process rather than any specific conceptual point. The acid test of success will be whether (or not) “bankable” companies begin to flourish in Kazakhstan’s electric distribution sub-sector.
About Mid-Term Tariff Policy
For the past year the ARNM has been working on a new approach to tariff setting for all natural monopolies. This new approach is the mid-term tariff policy2. (ARNM Order No. 30-OD, “On Approving the Instruction on Approving and Enforcing Tariffs for Mid-Term Period for Services to be Provided by Natural Monopoly Companies” dated 3 February 2003) The mid-term tariff policy is from three-to five-year length vs. a short-term (one-year) or long-term (over five years) duration.
The stated purpose of this new tariff policy is to provide a “non-discriminatory methodology for setting tariffs … to implement mid-term investment projects …” The intent of the tariff policy is to enable natural monopolies to implement an “agreed and approved” investment plan to modernize and rehabilitate infrastructure.
Once granted, a tariff would not be subject to change during its three-year term, except as noted below for force majeure events or violations. This approach could have a significant impact on the financial viability of regional electric companies.
Why is this mid-term tariff policy so important? The answer is “predictability”.
Predictability is very important because investors and credit grantors need a firm basis-a track record and/or a regulatory reputation and/or a transparent, clear and definitive policy statement-to enable an assessment of business risk in making lending or investment decisions. These concerns are greater during this current stage of the electric power sector’s reform due to the fragile state of finances for privatized RECs.
The way the mid-term tariff policy is interpreted and implemented by the ARNM will send a signal to natural monopoly company investors. If it is possible to predict with reasonable certainty whether a natural monopoly company will be provided an opportunity to earn a reasonable return on investment-including its cost of capital-then financial viability will become an achievable goal. If not, the “bankability” of investor-owned natural monopoly companies in the electric power distribution sub-sector will be difficult. These concerns are greater during this current stage of the electric power sector’s reform due to the fragile state of finances for privatized RECs.
However, the significance of the new tariff policy probably won’t be known until the ARNM has made several decisions that provide tangible evidence of the ARNM’s thinking and its approach to interpreting the new tariff policy. Otherwise, there are some good things about the new policy and some that are troubling. The good news is that RECs should have increased certainty about tariffs for three to five years. This is a clear improvement over an annual tariff setting process.
The tariff policy allows a return on new investment using the weighted average cost of capital to determine the rate of return. There have also been indications that the ARNM may consider allowing the use of accelerated depreciation3 to increase tariffs and cash flow. If done right, this would be a great success. (Instruction #185-OD on Approval of Rules Concerning Special Procedure for Costs Formation that are Used at Tariff’s Approval says that “application of the straight-line depreciation does not require its approval by the authorized body. The use of depreciation calculated by using other depreciation methods shall be agreed upon with the authorized body in an orderly manner”. ) Forward-looking tariffs developed on the basis of a REC’s investment plan?assuming the cost of capital is fully reflected in tariffs-would be a major feat for Kazakhstan’s electric power sector.
The Order suggests that the ARNM cannot change the mid-term tariff except for an event of “force majeure” or in the case of a violation by a natural monopoly company. Importantly, natural monopolies would be allowed to keep the savings from cost reductions until the end of the mid-term tariff term. This is appealing conceptually, but it may not offer immediate benefit if, as in the past, the full actual amount of operating and maintenance costs is not included in tariffs. If that practice were continued, the value of this provision in the new tariff policy would be reduced.
The ARNM regulates only transmission and distribution costs4; thus, the mid-term tariff does not regulate the price of purchased electricity. (The mid-term tariff does not regulate the price of purchased electricity. Actual purchased electricity costs are not under the RECs’ direct control (the price of purchased electricity is determined by the market), and are paid by customers.) This reduces a REC’s risk significantly because purchased electricity represents over 60% of its operating cost.
As for the matters in the new tariff that are either worrying unknowns or otherwise troubling there are several. First, there is considerable latitude for interpretation in implementing the tariff policy. As an example there may be interpretation of the new policy suggesting that mid-term tariffs may be restricted by the customer price growth index stipulated by the Indicative Plan of the social and economic development of Kazakhstan since the reference points the new Order embodies contain the repeated use of the phrase “… taking into account the Indicative Plan of Kazakhstan Social and Economic Development …”. If so, the end result of the mid-term tariff may be disconnected from the realities of a REC’s actual costs. Such a result would be contrary to the GoK’s stated interest to privatize them.
A related issue is that there is not a clear provision for the kind of flexibility that might be needed to adapt to the unforeseen, short of an event of force majeure. For example, if the GoK implemented a change in the tax code with a significant adverse impact on a natural monopoly company’s financial viability, it is not clear if a natural monopoly would have any recourse until the end of its mid-term tariff period. This is an unsettling risk where clarity would be comforting for prospective lenders and investors.
In the past, the full actual amount of certain costs (e.g., depreciation, materials, etc.) was not included in tariffs. It is not clear whether or to what extent this practice will be continued. If it is, the value of the new mid-term tariff policy will be reduced. Another notable unknown relates to the cost of capital. If natural monopoly companies cannot recover the full actual cost of capital, they may not be able to borrow the funds needed for their investment plans. Eventually, service quality will suffer as a result.
The kind of regulatory latitude included in the Order is probably unavoidable. It is difficult to envision a strong regulator without broad latitude in decision-making. These are decisions that the regulators around the world must balance objectively-and the key word is ‘balance’. Up to now, the ARNM has tried to keep tariffs down to shelter the population from the effects of “rate shock”. But if this practice is continued, it will ultimately lead to the deterioration of service. Then, the same customers the ARNM is trying to protect will suffer. In order to get tariffs to a level that will enable RECs to invest the funds needed to renew assets, it will be necessary to increase tariffs at a higher rate than inflation.
Additionally, the regulator will have to develop an image of a state body that pursues a consistent policy before lenders and natural monopoly company investors can make their investment decisions.
That is also why the ARNM should be encouraged to focus on the final result of the mid-term tariff policy. The resultant tariff amount should provide a reasonable basis for a REC to recover its costs and also obtain the capital needed to renew and expand the resources invested in the business.
Soon the first test case will be decided and some clarity will be brought to this matter. Several months ago, Kokshetau Energo became the first REC to take up the ARNM’s invitation to undergo a pilot implementation of the new mid-term tariff policy. The results will become effective by the end of 2004.
Financially Viable Distribution Companies are Important
The reason the results of the ARNM’s pilot tariff process are so important is that the experience of the past decade has demonstrated the essential role of the “last mile”5 of the electricity network. (The “last mile” - shorthand for the electric power distribution sub-sector - is the wellspring of the cash flow for the entire electric power industry.)
There is a growing recognition that without adequate tariffs and collection rates the electric power distribution sub-sector will fail due to insufficient profit and cash flow to support the investments needed to renew and expand physical assets. On a combined basis, the electric power sector needs three units of investment for every unit of revenue. That is very high compared to other industries. In the electricity distribution sub-sector, the investment to revenue ratio is one-to-one. The assets in question are “long-lived assets”. In the electric power generation sub-sector (the most capital-intensive segment), the life of an electric power generating plant is often 40 years or more. At the other end of the spectrum, electric distribution asset lives are shorter (five to 15 years), but still long.
If RECs must fund their investments without the ability to borrow, tariffs would have to be much higher, perhaps impossibly high. That’s why the electric power industry needs “bankable” RECs.
That’s where the mid-term tariff comes in. The results of the first application under this new tariff policy will soon become public knowledge. It will be an important signal, not only to RECs but also to the financial community. Good results will bolster confidence that Kazakhstan can accomplish its ambitious plans for the electric power sector.
The Owner / Manager’s Responsibility
The above may create the misleading impression that the successful transformation of the electric power sector rests entirely with the ARNM. However natural monopoly company managers and owners have critical responsibilities too. The most basic responsibility is to understand the “value exchange”-what is the value a REC provides to its customers in exchange for money? Both the REC investor and manager should realistically assess the linkage among cost, service quality, value creation, and profit. Only then they will be able to collaborate with the ARNM to achieve the best results for all parties concerned. Once the Agency and RECs agree that it is vital for RECs to be able to borrow the funds needed for investment, they could join forces to enlighten the banking sector on the needs-and the rewards-of lending to Kazakhstan’s electric power sector.
Conclusions and Recommendations
Based on the GoK’s commitment to privatizing RECs, the ARNM should focus on the overall result that will be created by the new mid-term tariff policy. This is an historic moment. If the stakeholders-including the GoK, the ARNM, RECs, and customers-collaborate effectively, they can produce lasting benefits for all. As a by-product, this result would contribute to sustainable benefits for Kazakhstan and all its citizens.
A review of the new tariff policy and its potential outcomes suggests several tariff-related actions to enhance the bankability of regional electric power companies:
Provide a competitive return on investment: In free markets, companies must attract capital, and the term “capital attraction” means just that. It is essential that RECs be able to earn a reasonable return on equity, pay the full cost of loans from profits and depreciation and pay dividends to investors.
Provide strong cash flow: Strong cash flow assures lenders that funds will be on hand to repay principle and interest. Thus the sensible use of accelerated depreciation on new investments can increase the company’s cash flow.
Monitor investment plan implementation: The ARNM should develop an oversight capability either on its own or by hiring technical consultants. This is needed to ensure that RECs are, in fact, implementing their investment plan as included in the tariff setting process.
Link cost to an explicit measurement of service quality: Key performance indicators (KPIs) should be developed and used to monitor the customer service quality performance of RECs. Performance results could then be factored into the next tariff review.
A central goal of power sector reform is to create efficient natural monopoly companies. The creation of “bankable” RECs would be a vital enabling event.
Kazakhstan’s RECs revalued their assets, creating sizeable increases in book value. But only state-owned RECs can use the higher revalued assets to set tariffs. Private investors paid so little, it is argued, they shouldn’t earn a return on the revaluation increase.
The uneven use of this principle will not serve all citizens equally. Every REC must renew the assets required to provide reliable customer service. Allowing only state-owned RECs to earn a return on their higher revalued assets ignores the fact that they paid no more for the revaluation increase than privatized RECs.
It may not be unreasonable to allow a return on revalued assets to enable privatized RECs as well as state owned RECs to finance their future needs. If RECs are to invest as needed, then all of them must earn amounts on a par with the asset base to be renewed. Conceptually, that should be a rationally revalued asset base. But there is a risk that a REC owner might not reinvest the higher return in the business.
This is the reason why the mid-term tariff policy implementation would be a better alternative to asset revaluation mechanism since the mid-term tariff policy suggests linking the company’s investment plan with its mid-term tariff which would serve to the country’s economic interests.
That’s why it is vital that the mid-term tariff works properly. A forward-looking tariff with a fair return on capital would be best. That would invoke the right behavior and business response. Customers would benefit from new investments and investors would be rewarded too-but only as investments are made.
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