Reviving Sri Lanka's power sector...

Continued from yesterday

RAM Ratings Lanka has published this report on Sri Lanka's power sector

Electricity sales - in giga-watt hours ("GWh") - mostly stem from the domestic and industrial segments. That said, domestic sales have been rising in line with the country's increased electrification, although the pace of expansion has decelerated after the tariff hikes in 2008.

With the end of terrorism and the upcoming coal-powered plants, however, overall tariff rates are expected to fall. Should a downtrend in tariffs materialize, RAM Ratings Lanka envisages demand from the industrial segment to pick up.

Regulation of the power sector

The Public Utilities Commission of Sri Lanka ("PUCSL") was set up in 2002, to regulate infrastructure industries, including the power sector. In March 2009, the commission's powers were enhanced with the passage of the Sri Lanka Electricity Act ("the Act"). This allows the PUCSL to exercise licensing powers and regulate tariffs 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-à-vis generating electricity. Meanwhile, private-sector participants can obtain licences to generate electricity so long as the plant's capacity is less than 25 MW. IPPs have been allowed to venture into the industry since 1996.

As a result, private participation has been increasing, accounting for as much as a third of the sector's installed capacity as at end-2008.

In tandem with this, the IPPs' contribution to the national grid has also been augmenting.

As at end-2008, IPPs fulfilled as much as 40.92 percent of the industry's total power demand. In view of the Act, however, private participation is likely to recede in terms of installed capacity.

Currently, the IPP sub-segment is also dependent on thermal generators to produce electricity; the remaining 16 percent rely on hydro sources. Within the thermal segment, the majority of IPPs use fossil-fuel-based technology to deliver power.

Based on publicly available information, RAM Ratings Lanka notes that hydro-power players have improved their profitability of late.

Their impressive profit performance is underpinned by lower debt levels, better tariff rates and heightened power generation.

We observe that these profitability indicators may entice further investor interest in the local power sector.

Profitability apart, these players have also sought to dilute their site risks via acquisitions. Thus far, such acquisitions have not overtly strained the companies' balance sheets; their credit matrices have remained intact.

From a private-investment perspective, the power sector is unique as it is a noncyclical industry.

As noted earlier, demand for electricity in Sri Lanka has also been increasing, hence remaining resilient even amid economic downturns.

This fundamental characteristic results in a stable or predictable cash flow (provided there is no off-taker default).

Secondly, operating risk is deemed moderate as the technology used in Sri Lanka are linear in interaction and have tight linkages.

Another unique feature of the power sector is the long life of the assets and the relatively low risk of obsolescence. In addition, power plants require hefty initial setup costs, but low ongoing capital expenditure.

On the flip side, the risks of these ventures should also be considered by investors or holders of debt securities.

Construction risk

An IPP's revenue risk only comes in after the plant's construction has been completed and it has been commissioned. Failure to complete on time can lead to cashflow deficiencies; under the PPA, the IPP failing to achieve the agreed milestones can be construed as a default.

The construction phase invariably poses the single largest risk; credit-rating agencies only upgrade an IPP's rating upon elimination of this risk. In Sri Lanka, the lack of long-term funding sources has led to promoters seeking banking lines. Banks, in turn, either grant funding based on the collateral or benefits from international agencies' refinancing programmes.

The PPA, which underscores the viability and attractiveness of the power project, is the most important contract supporting an IPP's creditworthiness.

RAM Ratings Lanka reviews the PPA to identify potential loopholes in the contract that may have a negative impact on the project's ability to generate revenue, and ultimately affect its credit 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 Lanka's rates are among the highest in the region. So much so that industries which consume a lot of energy have claimed that they have lost or are losing competitiveness in the global market.

There have been various tariff structures, i.e. thermal-powered plants' tariffs can be based on two components - capacity and energy charges.

The capacity charge constitutes of escalable and non-escalable components. The non-escalable module partially addresses the shareholders' returns and debt-servicing obligations.

The escalable component covers all administration and fixed operation and maintenance ("O&M") costs as well as related expenses.

Meanwhile, the energy charge is based on the actual units produced. This pricing methodology has, however, come under criticism, especially during the escalating oil prices witnessed in 2008.

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 power producers signing PPAs from January 01, 2008 onwards will have cost-based, technology-specific and three-tiered contracts. Previously, the contracts had been based on the "avoided cost" principle (i.e. the marginal cost that the CEB would have had to expend to generate power).

IPPs that had signed their PPAs before January 01, 2008 will have the discretion of either abiding by the agreed tariff or switching to the current structure.

RAM Ratings Lanka is also cognisant of the state's role in adhering to the spirit of the PPAs, as there are political implications.

In China, PPAs have been subject to renegotiations and numerous tariff reductions.

(To be continued)